Retail investors
A retail investor should incorporate a hedge fund into their investment portfolio if it will help them achieve their goals. Ideally retail investors would only make such an investment under the guidance of a financial planner. But the challenge that both financial planners and their clients face when it comes to investing, is to remember that investing is not a competition but rather that it is a means to an end. Which means the question financial planners need to answer is, how will investing in a hedge fund help my client achieve their investment goals? But before a financial planner considers their client’s investment goals, ideally, they will have their own house in order.
For financial planners, hedge fund investing starts at “home”
What does it mean for a financial planner to have their house in order before recommending hedge funds to clients? Firstly, it means that the financial planner has a clear investment philosophy and process that allows for the appropriate use of hedge funds. Secondly, that the financial planner abides by the relevant regulatory requirements for hedge fund investing.
An investment philosophy that incorporates investing in hedge funds
When considering the use of hedge funds for client portfolios, a financial planner ideally should have a clear, documented investment philosophy that incorporates the belief that there is a place for hedge funds as an appropriate vehicle for helping clients achieve their investment goals. In so doing, a financial planner ideally will have adopted at least three core principles or beliefs in their investment philosophy.
The importance of having an investment philosophy cannot be underestimated
Belief 1: It’s possible to generate positive returns in up and down markets
The starting point for any investment plan, is for a financial planner to have a clearly articulated investment philosophy which outlines the key principles that they believe hold true about investing. The importance of having an investment philosophy cannot be underestimated, as it serves as a reference point for all investment decisions. So, for a financial planner to be comfortable investing in a hedge fund, one of the fundamental investment beliefs they must hold is that it is possible to generate positive returns in all market conditions. This is a foundational principle for the use of hedge funds.
Belief 2: It’s possible to limit losses in down markets
A second principle would be that the financial planner believes it is possible and important to limit losses when markets fall. This may be particularly important for clients who are drawing down on their investments, such as those invested in a living annuity. In long-only portfolios diversification is generally the key method used to limit losses when markets fall, but a financial planner who uses hedge funds will believe that more can be done to limit the downside in a client’s portfolio.
Belief 3: Diversification is key, but not just across asset classes
A third principle may be that they believe in diversification, not just of asset classes, but of investment techniques or strategies. It would be a mistake to consider the use of hedge funds as simply the use of another asset class. Hedge funds are not homogenous investment solutions. They are characterised by a diverse range of strategies and investment techniques, and it is important that financial planners understand not only the mechanics of these, but also that they (and their clients) are clear on the consequences these techniques may have for their portfolios. For example, if a hedge fund is included in an investment portfolio to act as a “shock absorber” to mitigate downside movements in the portfolio, it must be accepted that the portfolio will lag the market, and potentially other investment options when the market moves positively.
We are fortunate in South Africa to have such advanced regulation of hedge funds which empowers both financial planners and clients to make informed choices
With these three principles in place, the financial planner has laid the foundation for the possibility of investing in a hedge fund. Thereafter they can consider whether a hedge fund is an appropriate solution for achieving client goals. It goes without saying that a financial planner should not consider using a hedge fund for a client unless they have a thorough understanding of any hedge fund they may consider using.
During the technology bubble of the late 1990s and early 2000s, Warren Buffett said that he and Charlie Munger could not invest in any technology companies because they didn’t understand them. If the world’s greatest investor can steer clear of an investment because of a lack of understanding, the most capable financial planner can take comfort that there is no embarrassment in doing the same if they do not
have a full understanding of the investment under consideration.
While historically hedge funds have had the reputation of being “black boxes” and that you must just trust the outcome, this is not the type of hedge fund in which a financial planner should be investing their clients’ money. We are fortunate in South Africa to have such advanced regulation of hedge funds which empowers both financial planners and clients to make informed choices when investing in a hedge fund.
Meeting regulatory requirements for hedge fund investing
There are different ways to invest in a hedge fund. For clients where Retail Investor Hedge Funds would be more appropriate, the financial planner could invest directly into a Hedge Fund CIS, if they are licensed for the “CIS Hedge Funds” product category. A financial planner may also have clients who “qualify” for Qualified Investor Hedge Funds, in which case they are likely to invest directly into a QIHF. Again, they need to be licensed for the appropriate product category.
A financial planner in South Africa needs to be authorised by the FSCA under the specific product category 1.26 (Participatory Interests in Collective Investment Schemes – Hedge Funds) to be legally permitted to advise clients on hedge funds. This authorisation obviously indicates that the advisor has met the necessary “fit and proper” requirements to understand and advise on the complexities and risks associated with hedge funds.
A key potential benefit of using a hedge fund is to offer greater diversification
Financial planners without the 1.26 Participatory Interest authorisation can, on certain platforms, use hedge funds that are run through a life licence, eg Living Annuity or Endowment, but generally they are not allowed to advise on hedge fund investments in discretionary portfolios or Retirement Annuities.
Having got one’s own house in order, the financial planner is well positioned to consider the client-specific factors which are relevant in determining whether a hedge fund is appropriate for incorporating into a client’s investment plan.
Client factors to consider when deciding if a hedge fund is appropriate
Investment objectives and goals
If investing is a means to an end, then it is about helping clients achieve both their life and financial goals. This means the key question to consider is: What does the client hope to achieve by investing in a hedge fund? Is it absolute returns, diversification, capital preservation, or a specific exposure? The hedge fund’s strategy must align with these goals.
Risk required, tolerance and capacity
Given that hedge funds are generally considered higher risk than traditional investments the financial planner must thoroughly assess the client’s risk profile. This is a three-dimensional assessment which incorporates the following:
- What is the risk that is needed for the client to take on (risk required) in order to achieve their investment goal?
- How resilient is the client’s psychological willingness (risk tolerance) to take on the risk that will be associated with the hedge fund investment?
- What is the client’s financial ability to withstand potential losses (risk capacity) considering their time horizon, wealth level and income stability?
Liquidity needs
In South Africa, financial planners are fortunate to be able to access Retail Investor Hedge Funds which provide daily liquidity. But if they are considering using a Qualified Investor Hedge Fund, they would need to ensure that the client is comfortable with the greater illiquidity of these funds, which may only allow redemptions every 30 or 90 days. The financial planner must ensure the client’s liquidity needs are met, and they are comfortable with the illiquidity inherent in the QIHFs.
Existing portfolio and diversification
How will the hedge fund fit into the client’s overall investment plan and existing portfolio? Does it offer true diversification by having a low correlation to existing assets? A key potential benefit of using a hedge fund is to offer greater diversification. If a financial planner intends to include more than one hedge fund, they should aim to select funds that are uncorrelated with each other and with broader market movements.
Tax considerations
Depending on how the client accesses the hedge fund, whether directly into a CIS as a discretionary investment, or via an investment vehicle like an Endowment or RA, the financial planner will need to consider the impact on the client’s overall tax situation.
Regulatory factors
Regulations do influence when a financial planner can consider using a hedge fund in a client portfolio. For pre-retirement Regulation 28 compliant portfolios, up to 10% of the portfolio can be invested in hedge funds, with up to 5% in a single fund of hedge funds, and up to 2.5% in an individual hedge fund. There is no regulatory limit on the use of hedge funds in Living Annuities or in Discretionary Investments. At this stage hedge funds are not allowed to be used in a Tax-Free Savings Account.
Institutional investors
Widely seen as the pioneer of institutional investing in hedge funds is the Yale University Endowment Fund in the US. David Swensen managed Yale’s endowment for over 35 years, under “The Yale Model”, a framework for institutional investing that he developed alongside then senior endowment director Dean Takahashi. The Yale Model has remained the University’s primary investing scheme – and has become the industry standard over the last three decades.
The Yale Model favours broad diversification of assets, allocating less to traditional US equities and bonds and more to alternative investments like hedge funds, private equity, venture capital and real estate. This approach has generated exceptional long-term returns, consistently outperforming other large institutional investors. Other large US university endowments such as Harvard, Stanford, Princeton, MIT and others have followed Yale’s lead in successfully incorporating hedge funds into their portfolios for diversification and enhanced returns.
The move to hedge funds can be seen in the shift in the Yale Endowment’s asset allocation over time, from 1989 when the endowment had 75% of its assets invested in US equities, bonds and cash; to 2019 when the Yale Endowment had over 60% of its assets invested in alternative investments.
If investing is a means to an end, then it is about helping clients achieve both their life and financial goals
South African retirement funds and institutional investors don’t have the same level of flexibility as The Yale Model provides. South African retirement funds have to adhere strictly to the prudential investment limits and operational requirements stipulated by Regulation 28 of the Pension Funds Act of 1956 and the broader regulatory framework under CISCA. The specific provisions of Regulation 28 regarding hedge funds were significantly updated relatively recently and came into effect in January 2023.
The amendments introduced a clear definition of a “hedge fund” that aligns with the Collective Investment Schemes Control Act (CISCA). This means that for an investment vehicle to be considered a hedge fund under Regulation 28, it must be registered and regulated as a Collective Investment Scheme (CIS) in South Africa.
Regulation 28 now explicitly sets a maximum aggregate exposure of 10% of the fair value of a retirement fund’s total assets that may be invested in hedge funds. This limit was previously bundled with private equity and other “excluded assets” under a collective limit of 15%, but the 2023 amendments separated these categories.
While Regulation 28 primarily focuses on the aggregate limit, industry practice and guidance from the FSCA (Financial Sector Conduct Authority) provide implicit sub-limits for diversification within the hedge fund allocation:
Fund of Hedge Funds: A retirement fund typically has a maximum allocation to a fund of hedge funds (a portfolio that invests in other hedge funds) of 5%.
Single Hedge Fund: A maximum allocation to any single hedge fund is usually limited to 2.5%.
These sub-limits ensure that even within the hedge fund allocation, there is sufficient diversification across different strategies and managers, mitigating concentration risk.
Regulation 28 applies the “look-through” principle to ensure that funds cannot circumvent investment limits by investing in an intermediary vehicle that then invests in restricted assets.
However, for hedge funds (and private equity funds), the amendments generally state that a fund does not need to apply the look-through principle in respect of the underlying assets of the hedge fund. Instead, the investment into the hedge fund itself is disclosed as an investment into the “hedge fund” asset class, and it counts towards the 10% limit.
The “look-through” exemption for hedge funds and private equity funds does not, however, apply if the underlying investments of the hedge fund are in infrastructure assets. In such a case, the exposure to infrastructure through the hedge fund will count towards the overall infrastructure limit (45%) set in Regulation 28. This prevents funds from using hedge funds to bypass infrastructure investment limits.
Regulation 28 explicitly prohibits retirement funds from investing in crypto assets (directly or indirectly), reflecting concerns about their volatility and unregulated nature. This means that the look-through exemption is unlikely to apply to a hedge fund that primarily invests in crypto assets, which means such a hedge fund would probably not be permissible for a retirement fund.
Hayden Reinders, convenor of the ASISA Hedge Funds Standing Committee, hopes that with increased attention on hedge funds, their track record as Collective Investment Schemes and their consistent performance will encourage local retirement funds to take up the full 10% asset allocation into hedge funds. He says, “Although the amendments to Regulation 28 of the Pension Funds Act, allowing local pension funds to invest 10% of assets into hedge funds, came into effect at the beginning of 2023, most retirement funds are nowhere near the 10% maximum, which means there is plenty of room for growth.”
The regulatory provisions of Regulation 28 and CISCA with respect to hedge funds ensure that a retirement fund’s hedge fund allocations are within approved limits and managed with appropriate oversight and transparency. It means that a retirement fund is unlikely to do significant damage to their overall portfolio if they get their hedge fund selections wrong. But more importantly, with a robust due diligence process, retirement funds can use hedge funds to enhance the diversification of their overall portfolio and take advantage of the opportunity to generate absolute returns and increase downside protection. This gives the retirement fund the benefit of enhancing risk-adjusted returns for the overall portfolio.
