Hedge funds offer retail investors capital protection and diversification benefits

With new regulations finalised and hedge funds preparing to be registered with the Financial Services Board (FSB) as collective investment scheme portfolios, the time has arrived for retail investors to include an allocation to hedge funds in their portfolios.

Rene Miles, Managing Director of Novare Wealth, says there are good reasons to do so – in addition to the benefits investors derive from stricter oversight of the industry.

“The two most important benefits of including hedge funds as an additional alternative asset class in an investment portfolio are capital protection and asset class diversification.

“South African hedge funds have been successful in protecting capital and minimising drawdowns, resulting in enhanced returns and lower risk in the overall portfolio. In terms of diversification, hedge funds respond differently to market conditions compared to traditional asset classes, resulting in a low correlation with other assets,” said Miles.

Compared with traditional asset managers, hedge fund managers have a more sophisticated suite of investment instruments at their disposal. Traditional portfolios tend to be more volatile, due to systematic risk exposure, whereas hedge funds are able to more effectively minimise downside risk.

They strive to deliver consistent returns which, when compounded, translate into superior long-term performance. Because of their capital protection focus, the benefits of including hedge funds in a portfolio are particularly evident during times of high volatility.

Miles said: “For financial advisers and investors, there is merit in blending a credible balanced fund with a hedge fund. Bearing in mind the risk and return objectives of the investment portfolio, an appropriate hedge fund, or fund of hedge funds, can be selected to compliment the asset mix.”

She added that the same investment process adopted when selecting any other unit trusts should be adhered to with hedge funds, with a thorough investigation before selection.

It is, however, reassuring that the inclusion of hedge funds under the Collective Investment Scheme Control Act (CISCA) means they are subject to strict investment and compliance requirements to support investor protection.

Miles noted that hedge funds in South Africa are very different to their offshore counterparts, which in the past have sometimes been the subject of negative headlines.

“Locally, hedge funds were initially established for institutional clients like pension funds, which are relatively risk averse. The result is that domestic hedge funds have always been risk cognisant, with a capital preservation focus. They use far more conservative strategies and tend to be less exotic than the complex structures used internationally.”

In terms of determining an appropriate or optimal allocation to hedge funds in a multi asset portfolio, Miles said a starting point is Regulation 28 of the Pension Funds Act, which allows for 10% of a retirement fund’s assets to be invested in local hedge funds.

“Retail investors should not expect hedge funds to always outperform the market, particularly bull markets. However, their inclusion in a portfolio can result in lower volatility, asset class diversification, capital preservation and stronger risk adjusted returns,” she said.