Hedge funds have had a torrid time this past year but still have their place in retirement planning says Ben Mountain
Over the last decade hedge funds have become readily available to the retail investor and diversified portfolios are often constructed with exposure to alternative investments alongside traditional asset classes such as equities and fixed income.
Traditional long only investment funds operate in a relative return environment where performance is measured against a predefined benchmark or peer group and as such are likely to deliver negative absolute returns when markets trend down. In contrast, hedge funds reside in an absolute return world and generically see their 'raison d'etre' to generate positive returns, within a specified level of risk and at any point during an economic cycle. The combination of these objectives and a focus on preservation of capital has resulted in hedge funds becoming an increasingly important aspect of retirement planning.
The hedge fund industry will look back on 2008 as an extremely painful period. A multitude of factors contributed to what transpired to be the worst year on record: a global economic slowdown leaving much of the world in recession; a global banking crisis which led to many financial institutions going to the wall or becoming nationalised; liquidity drying up just as risk aversion sets in (thereby further fuelling fund redemptions) and then being capped by the Madoff fiasco; the biggest financial fraud in history.
Indeed, the last time the hedge fund community was structurally challenged, albeit not to the same extent, was in 1998 with the collapse of Long Term Capital Management (LTCM). LTCM's demise came on the back of the Asian financial crisis in 1997 and the Russian Government's default on its sovereign bonds in August/September 1998. While the backdrop was very different, the common thread between 1998 and 2008 was excessive leverage in the system. It should be noted that the following year, for those hedge funds that survived 1998, proved to be one of the most rewarding with a return of +23.43% (Credit Suisse/Tremont Hedge Fund Index). 2008 will be remembered for different reasons and will be a permanent scar on the hedge fund industry. Despite the disappointing returns witnessed from the asset class, hedge funds still managed to outperform returns delivered by equities in both developed and emerging markets.
The landscape has undoubtedly changed, but the opportunities that now exist could result in outsized positive returns ahead - without the use of much leverage (if at all).
Planning a portfolio for retirement requires a considered assessment of where a client is in their lifecycle. A client in their late 20s to mid-40s should be seeking to achieve high real returns, which may result in a high allocation to real assets such as equities and property. Exposure to hedge funds during this stage may be minimal. As the client matures, the focus should move towards growing the 'nest-egg' while keeping a keener eye on downside risk and an increased allocation to hedge funds at the expense of equities may be more appropriate. On retirement, investment goals and objectives change significantly. Stability of returns becomes key for the retiree, tolerance for risk diminishes (although capacity for risk may be relatively high) and drawing down on assets is often a necessity. At this stage, hedge funds can form an integral and significant element of a portfolio, smoothing returns and providing significant downside protection.
A typical multi-manager, multi-strategy fund of hedge funds (FoHF) will seek to generate a return of between 8-12% per annum (after fees) over the course of a full business cycle with volatility (risk) similar to world government bonds. As a result, investing in a broad based FoHF should be seen as a medium to long term proposition through which investors can benefit from the power of compounding over time.
The issue of cash flow is extremely pertinent when structuring a portfolio for an individual entering retirement. It is essential for an investment manager to address the liquidity needs of a retiree. While hedge funds do not generally provide an income stream and have less frequent dealing dates than some securities, careful planning can ensure that short term liquidity needs are met. A typical FoHF may offer liquidity terms of a monthly subscription but quarterly redemption and therefore investors seeking to access their invested capital on a short/immediate term basis may need to raise it from other more liquid investments such as bonds or equities.
A common criticism of hedge funds is the issue of taxation. Many hedge funds are domiciled in offshore jurisdictions such as the Cayman Islands and, for a UK tax payer, this means that gains, when crystallised, are subject to income tax rather than capital gains tax. For those saving for retirement this issue becomes less relevant if the investment is held within a self invested personal pension (SIPP) or small self administered scheme (SSAS).
Traditionally, a portfolio's risk profile reduces as an investor approaches retirement and allocations to real assets such as equities and property are often reduced in favour of high exposure to fixed income and cash. The addition of hedge funds to a client's portfolio can reduce the overall risk profile without necessarily sacrificing any market rally.
In conclusion, hedge funds should be viewed as a medium to long term investment. Allocations to the asset class should be determined in light of a client's stage in their lifecycle as well as considering their willingness and capacity to take on risk. Lessons will indeed be learnt from the unprecedented market conditions witnessed in recent times and the hedge fund world will undoubtedly be a very different place. However, hedge funds' core principles remain attractive to investors who seek either to reduce volatility and enhance compounded investment returns over time, or who wish to follow a more sophisticated risk/reward strategy as they approach retirement.
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