The Institutional Perspective

Finance Week


02 October 2008


By Judy Gilmour


THE PRIMARY LONG-TERM goal of a retirement fund is to provide its members with a decent income at retirement. An appropriate strategic asset allocation representing the percentage weighting of assets among the different asset classes – equities, bonds, property, cash and offshore investments – is key to meeting members’ expectations.

Fatima Vawda, MD of 27four Investment Managers, says that with more than 90% of the investment performance of a retirement fund being driven by asset allocation, the importance of an appropriate asset mix is critical.

“In South Africa, Regulation 28 of the Pension Fund Act restricts and determines the exposures to the different asset classes. Currently, hedge funds fall within the ‘other’ asset class category and limited to a maximum allocation of 2,5%. The Act is currently under review and may be amended to increase the allocation to hedge funds but for the time being increased exposure to SA hedge funds can be achieved through variable rate debenture type structures.”

Vawda says pension funds have become increasingly aware of the need to diversify their sources of return and reduce their risks. “Funds invested primarily in equities and bonds – as most typically are – tend to struggle in bear markets as the value of their assets drop and their liabilities increase due to the fall in bond yields. Hedge funds, if used efficiently, can be an independent source of return – a buffer against volatility and a tool for overall risk reduction.”

To correct common misconception Vawda says hedge funds aren’t a separate asset class. “They merely present a collection of investment strategies that invest in mainstream asset classes, defined by two underlying dimensions: skill and style.”

Vawda says hedge fund investing holds special risks and special benefits. “A hedge fund portfolio should contain properties suited to that retirement fund, As with any investment you should know under what circumstances the investment will underperform and in particular what factors the investment is exposed to – for example, liquidity and size – to ensure any undesirable exposures are minimised at the overall fund level. Certain styles of hedge funds make very good diversifiers of ‘long’ equity portfolios under all market conditions and some don’t.

“Low risk hedge funds – such as market neutral or relative value fixed income – could be introduced as part of the defensive portion of an investment strategy or as part of or as an alternative to the fixed income allocation. Long/short equity hedge funds could be used alongside the long-only equity allocation for the  provision of ‘insurance’ or ‘downside protection’ or even return enhancement. An adept fund of funds manager will ensure a good ‘protective’ blend of managers in the overall hedge fund portfolio.”

Vawda says trustees should avoid overexposure to any single manager. “In the event of a ‘blow-up’ an overexposed allocation will affect the performance of the fund of funds. Offshore, this year has seen a series of hedge fund blow-ups due to the sub-prime crisis, where banks pulled leverage or investors demanded their money back from illiquid strategies.

“Trustees must also understand the fund’s withdrawal (liquidation) terms and conditions. Many funds of hedge funds, mostly those offshore, apply restrictive gates, making it difficult to access funds – particularly during a panic period when funds can’t achieve the liquidity to meet the redemptions.

“Investors must also understand the level and nature of the leverage being applied at the underlying manager and fund of fund level and be wary of funds of hedge funds that have direct ownership in underlying funds. The question in this case is whether they allocate across their internal hedge funds in a way that’s adding value and free of conflicts? Other key considerations are whether there’s reward for the higher fees being charged and does the fund make use of an independent risk manager and administrator?”

Vawda says fund of hedge funds have performed poorly in SA this year, with most managers delivering negative returns year-to-date – despite using cash as their hurdle rate. “The average return year-to-date endJuly was -1,30%, with the highest at 3,36% and the lowest at -6,74%. Funds that did well during the bull market suffered during that volatile period. Often, in a multi-manager context, fund of fund managers tend to be reactive ‘after the event’ than cater for that rare or random event all the time.

“Also, the ability to change portfolios is slow, as most often underlying managers provide 60-day liquidity terms and that makes it difficult for fund of fund managers to react quickly to changing circumstances.”