Trustees of pension funds and retail investors need continued coaching on the value of hedge funds if the industry wants to keep growing at a record pace, says Kagiso Mathole, portfolio manager of Novare Investments.

The upheaval in financial markets caused by shocks such as the COVID-19 pandemic and Russia’s invasion of Ukraine significantly changed how investors behave, increasing the appeal of alternative investments such as hedge funds to boost returns.

Confronted with the fastest pace of interest rate increases in decades, rocketing inflation and slowing economic growth, investors panicked, causing market volatility to soar.

The events led to the second worst year for stock markets and the most severe for US bonds, breaking the natural pattern in which the two asset classes move inversely. Bonds are typically seen as a haven in times of uncertainty, and shares are considered riskier while offering higher returns.

One of the few beneficiaries of the turmoil in financial markets has been hedge funds, which can be used to diversify or reduce risks in a portfolio and generate positive returns even when markets are falling.

Hedge funds are growing in popularity, with assets under management in the local industry soaring to an all-time high of R76 billion in 2021, driven by improved returns and inflows, according to the latest Novare Hedge Fund Survey. The R14 billion increase in assets was the biggest in nominal terms yet, while the 23% growth was the second fastest in seven years.

Hedge funds make up only a tiny portion of the savings pool in South Africa. That’s despite South Africa becoming the first country in the world to implement comprehensive regulations for hedge fund products in 2015.

Extra diversification

There are hopes that the industry may experience further growth following legislative changes allowing pension funds to invest 10% of their assets into hedge funds and 15% into private equity investments. Previously, retirement funds could only invest a combined 10% in both.

The performance of traditional equity and fixed-income markets in 2022 demonstrated that constructing a portfolio by splitting it into bonds and shares across different sectors, companies, sizes, and regions may no longer guarantee success and diversification.

Hedge funds are rising in popularity because investment mandates given to money managers are more flexible, meaning they can use more strategies to generate returns. They don’t need to stick to conventional asset classes, are more nimble and regularly specialise in a particular market segment they have mastered.

Fees are often a point of contention and are perceived to be higher than other investments, as hedge funds charge management and performance fees.

However, these expenses have decreased considerably and must be weighed against after-fee performance. Furthermore, hedge funds aim to deliver better risk-adjusted returns, outperform their benchmarks with less volatility, and add to portfolio diversification.

According to the Novare Hedge Fund Survey for 2021, managers are willing to negotiate for lower fees with institutional investors, such as retirement funds, with many of them indicating this is already happening.

Novare has researched the industry for almost two decades, and for the annual report surveyed 64 asset managers who collectively manage more than 161 uniquely mandated hedge funds.

Clear fee structures

While some believe they charge a fair fee, most respondents agreed that costs could be negotiated down if the investment is large enough, there is an existing relationship, a long lock-up or a prolonged period of poor performance.

At the very least, it’s worth a discussion. There’ll be no growth in the industry unless investors are continuously educated and coached on the benefits of hedge funds and the misperceptions about fees.

Retail investors and trustees of pension funds need to explore all available options to protect their portfolios and retirement assets.

The industry must effectively communicate the benefits of hedge funds and their fee structures in clear and straightforward terms for investors to understand and make informed decisions.

This year has been bumpy, and the outlook is still being determined.

Investors are still guessing whether the world’s most influential central banks will keep raising interest rates, how stubborn inflation is, or if a global recession is on the cards. The collapse of US banks and Credit Suisse have spurred fears that the crisis may slow the world’s economy by hindering lending. The International Monetary Fund has warned that the sharp surge in interest rates may cause further instability in the financial system.

While all this chaos may seem intimidating to investors used to tucking away their funds in traditional investments, hedge funds thrive in this environment.

Diversity is the name of the game. All viable investment opportunities should be explored in a world that is fast changing, and space should be left in any portfolio to protect from downside risks or generate potential upside.

Otherwise, there is a risk that returns are left on the table when other eggs in the investment basket are cracking.

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