Pros and cons of Hedge Fund Investments

Pros and cons of Hedge Fund Investments
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Hedge funds can be seen as safe investments because they have the potential to deliver positive returns when share markets are falling. Due to the uncorrelated nature of their returns when compared to the traditional asset classes, they can provide the benefit of overall portfolio diversification.

Risks of hedge fund investing

Historically many hedge funds have delivered disappointing returns whilst charging high fees. They also often use financial derivative instruments (such as futures and options) to increase levels of exposure to certain assets. Financial derivative instruments have no intrinsic value as they are just contractual commitments. They are vulnerable to market movements and the ability of the contractor to pay. As a result, their use can make the hedge funds relatively risky, too.

In addition, successful hedge funds have also often been overly reliant upon the skills – or luck – of a single individual. This makes it difficult to be fully convinced about their ability to achieve consistent and reliable long-term performance.

The two main risks are:

  • Credit risk, and 
  • complexity risk.

How big is the hedge fund sector in South Africa?

The South African hedge fund market is currently relatively small but it is growing. At the end of 2022 there were 216 registered funds with a combined value of R113 billion. Hedge funds fall under the Collective Investment Schemes Act and are regulated in much the same manner as unit trusts. South Africa was the first country in the world to introduce hedge fund regulations in 2015. 

Retirement funds: hedge fund exposure and “alternative investments”

Recent pension fund regulations now allow retirement funds to allocate up to 10% of their assets to hedge funds (and up to 15% of their assets to private equity, or unlisted, investments). 

These potential allocations are becoming more important as the opportunity set on our listed share market has reduced steadily over time. Companies have delisted from the Johannesburg Stock Exchange to avoid compliance and cost requirements, as well as public scrutiny of their business dealings and management remuneration.

Hedge fund exposure beyond your retirement fund?

At Netto Invest we have taken the view that a potential 10% allocation within a retirement fund would be sufficient hedge fund exposure for almost all investors, and that it would be unnecessary to supplement this with additional allocations elsewhere. 

“Hedged equity” as a preferred investment strategy

It is worth noting that a number of funds used within our client portfolios for many years make use of “hedged equity” exposure. This is a broader and safer alternative to the relatively common “market neutral” hedge fund approach. The “hedged equity” approach involves investing in a number of different shares spread across a range of sectors for the long exposure, and obtaining the short exposure through a standard futures position (e.g., the S&P 500 Index or the JSE All Share Index) that is always easy to trade at short notice if required.

In addition to the hedged equity position, it would also be possible for a fund to increase its alternative investment exposure through other holdings (e.g., physical gold). 

As always, an appropriately balanced and diversified investment portfolio offers you the best probability of achieving your investment goals over time. At your next annual review, ask your CERTIFIED FINANCIAL PLANNER® professional about the advisability of including hedge fund investments as part of your financial plan.

By Richard Sparg, CFP® CA(SA)