IN A NUTHSELL: Regulation 28 of the Pension Funds Act allows retirement funds to allocate up to 10% of their capital to hedge funds. Let’s consider how retirement funds can invest in this asset class.
Pros and cons
The benefits that hedge funds typically offer, include:
- Portfolio diversification: Hedge funds may offer low correlation to traditional equity and fixed-income markets. In other words, when the equity markets decline sharply, a low correlated hedge fund could perform better or even deliver positive returns.
- Reliable returns: Hedge funds are structured to outperform markets in times of volatility, due to their low correlation to traditional assets, and especially during market downswings.
There are also some pitfalls to consider:
- Fees: Management and performance fees are typically higher than normal unit trust fees. This is due to the more complex strategies employed by these funds, with their accompanying higher expenses.
- Lock-in: As hedge funds are not limited to which assets they are allowed to invest in, these may typically include unlisted assets. The latter cannot be readily traded, as is the case with listed equities, which results in a ‘lock-in’ of some of the fund’s underlying capital. The fund manager bridges this liquidity issue by placing a restriction on when money can be withdrawn, typically monthly or quarterly for large investors.
Allocation to hedge funds
Hedge funds are regulated in South Africa in accordance with the Collective Investment Schemes Control Act. Basically, the Act differentiates between two types of investors in hedge funds: retail (man/woman in the street) and qualified investors. Hedge funds are also divided into these categories. Retail investor hedge funds have a less risky investment approach, whereas qualified investor hedge funds are aimed at experienced and institutional investors (such as retirement funds). The latter should also be able to invest R1m or more in a fund.
The regulation of hedge funds has opened the door for any person who can meet the minimum monthly contribution and accept the lock-in period, to invest in these funds. The contributions are typically at the higher end of what unit trusts require, but still manageable for individual savers.
Most retail investor hedge funds allow for monthly and one-off contributions. Thus, gone are the days when hedge funds were perceived only as an investment for high-net-worth individuals.
Explaining hedge fund fees
The fees charged by hedge funds may seem expensive at first glance. Running a hedge fund, however, can be more expensive than managing a unit trust. The aggregate value of a fund’s underlying assets is also an important determinant of the fee percentage.
The total assets under management by hedge funds was just over R100 bn split between a 100 or so funds while there are balanced funds worth R170 bn each! Certain fund expenses, such as research, staff costs, marketing and administration, are fixed and almost the same for a small R100m hedge fund as for a R100bn unit trust. For this reason, it is important to consider a fund’s returns net of fees, rather than a total investment charge, when comparing various funds. Hedge funds typically split their fees, in a similar way as unit trusts, as follows:
- Total expense ratio: The percentage of the average net asset value of a fund that was incurred as expenses, levies and fees with respect to the management of the fund.
- Transaction costs: The percentage of the net asset value of a fund expensed as costs to buy and sell assets for the fund.
- Performance fees: The fund manager’s cut, charged as a percentage, on the outperformance of the fund above its benchmark. This fee is usually included in the total expense ratio and should, for the sake of transparency, be disclosed separately in the monthly fund fact sheets.
- Total investment charges: The aggregate of the total expense ratio and transaction costs, expressed as a percentage of the fund’s net asset value. When considering the total expense ratio of different hedge funds, it is important to note that a high ratio does not necessarily relate to poor performance and a low ratio does not mean good returns.
Retirement fund allocations
In terms of Regulation 28 of the Pension Funds Act, retirement funds are allowed the following maximum allocations to hedge funds:
Aggregate maximum allocation
Per fund of hedge funds
Per hedge fund
CISCA: The Collective Investment Schemes Control Act. South Africa became the first country in the world to put in place comprehensive regulation for hedge fund products in April 2015.
Correlation: A statistical measure that expresses the extent to which two variables are linearly related (meaning they change together at a constant rate).
Diversification: An investment strategy used to manage risk. Rather than concentrate money in a single company, industry, sector or asset class, investors diversify their investments across a range of different companies, industries and asset classes.
NAV: Net asset value means the total market value of all assets in a portfolio including any income accruals and less any deductible expenses, such as audit fees, brokerage and service fee charges.
Qualified investor hedge funds (QIHFs): Are aimed at experienced or institutional investors who have R1m or more to invest. In addition, the investor, or his/her appointed financial adviser, requires demonstrable experience and understanding to make an informed investment decision when it comes to hedge fund investing.
Retail investor hedge funds (RIHFs): Are aimed at the general public as per CISCA classification. These are typically hedge funds with a less risky investment strategy.