Adding a hedge fund sweetener to retirement funds
Excessive media coverage of isolated hedge fund failures has led to the whole industry of eight thousand funds being unfairly tainted with the same brush, argues Lizelle Steyn, manager of Alternative Investments at Nedgroup Investments.
â€œHedge funds are actually innovative investment vehicles and for decades where the smart money â€“ such as that of the Harvard and Yale pension funds has flowed. Unfortunately, hedge funds have often also unfairly become the scapegoat for any unusual market or currency movements. In 1992, for example, the British Pound devalued so much that it dropped out of the European Currency System. It was initially believed that this too was caused by hedge funds, but a study published by the International Monetary Fund showed no evidence of market manipulation by hedge funds.â€
She says the damaging effect of one hedge fund failure to the reputation of these funds is often magnified by the myth that all hedge funds form part of one homogeneous asset class. In truth, there is an assortment of strategies behaving very differently under different market circumstances, all with different risk profiles and often displaying very low correlation with one another. Speaking of hedge funds as an asset class would be like speaking of unit trusts as an asset class.
â€œSimilarly, dictionary entries for hedge funds stating that they â€˜offer investors the possibility of extraordinary gains with above-average riskâ€™ are misleading. The majority of South African hedge funds are more concerned with capital protection than with â€˜shoot the lights outâ€™ returns. This is evident from their benchmarks, which are typically inflation plus five percent or cash plus three percent. On the other hand, thinking that all hedge funds offer capital protection is equally dangerous. Some South African hedge funds in the Trading category aim to outperform the ALSI 40; such outperformance would require a far more lenient risk budget.
â€œAnother common myth is that hedge funds are too risky and inappropriate for retirement funds. Looking at the consistently positive rolling 12-month performance of the Nedgroup SA Hedge Fund Index, the low volatility of this index and the small number of negative months, hedge funds clearly carry much lower market risk than the three traditional asset classes (equity, bonds and property). Importantly, these hedge fund returns are for the entire group that submit monthly data to the Nedgroup Hedge Fund Review. Most individual underlying hedge fund returns would be more volatile, which makes investment in a fund of hedge funds preferable.
â€œUnfortunately, operational risk (particularly fraud and poor business management) is higher - mainly due to the unregulated nature of the hedge fund industry. But a multi-manager approach can reduce the latter risk greatly. Unless pension fund trustees are very familiar with hedge fund techniques and the risks of the unregulated environment, the fund would be better off starting out with a fund of hedge funds, that diversifies across different hedge fund categories and which is managed by a team skilled in selecting and monitoring hedge funds.
â€œWhy would a retirement fund want to invest in hedge funds in the first place? Early Modern Portfolio Theory, as first theorized by Markowitz in 1959, even before hedge funds became popular, showed how holding short positions in a diversified portfolio can further push out the efficient frontier to the left. In other words they enable higher returns for the same level of risk (as illustrated by the green curved line in the accompanying graph) or the same level of returns, but at a lower level of risk. Several empirical studies, among others the 2000 Harvard study by Elizabeth Darst, also found that adding hedge funds to a long only balanced portfolio (for example, the core portfolio prescribed by the pension fund consultant) significantly increases the efficiency of that balanced portfolio.
But not just any hedge fund or fund claiming to be a hedge fund would be able to offer the sweetener of higher returns at the same level of risk. The fund should meet all of the following three critieria:
Â· Does it have a low correlation to the different components of the core portfolio;
Â· does it, on a rolling 12-month basis, generate returns consistently exceeding cash by at least 3% and:
Â· are those returns generated at low levels of volatility - similar to that of bonds?
â€œRetirement fund regulation currently allows retirement funds only a 2.5% allocation to hedge funds â€“ classified as â€œotherâ€, but this limit could increase in the near future. Many studies show that a much higher allocation to hedge funds would be ideal, considering the risk-return characteristics of these funds. But ultimately, you would rely on your pension fund consultant for an indication of how much to allocate to these risk-return enhancers.â€
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