December 2007

Hedging the bets

The hedge fund industry can trace its roots back to the middle of the last century yet for the majority of its existence has only been accessible to the institutional market and ultra high net worth individual. Over the last decade hedge funds have become readily available to the retail investor and are now often incorporated alongside traditional asset classes such as equities and bonds when constructing a well diversified investment portfolio.

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. It is a hedge fund's objective to generate positive absolute returns combined with a focus on preservation of capital that makes them an attractive asset class for a retiree.

Hedge funds aim to exploit pricing anomalies across all asset classes including fixed income, equities, currencies and commodities. Positive returns can be made irrespective of market direction. This can provide an uncorrelated return stream to traditional assets (stocks and bonds), adds diversification benefits to the investor and improves the risk-adjusted return profile of a portfolio. Hedge fund strategies vary from relatively simple long/short equity funds (an investment manager will purchase stocks (long) that he deems are undervalued with the expectation that the share prices will appreciate over time and sell companies (short) that are overvalued and likely to derate), to highly sophisticated strategies that employ complex derivative structures. Given the degree of complexity of some of the underlying positions and broad range of strategies a good starting point for private client investors, including those within their retirement years, is to invest in a fund of hedge funds (FoHF). A FoHF investment manager is able to build a portfolio that is broadly diversified across multiple strategies and managers hence reducing both strategy and manager specific risk.

Lifecycle issues

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 i.e. returns above inflation, 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 e.g. 5%. As the client matures, the focus should move towards growing the 'nest-egg' while keeping a keener eye on downside risk. 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 (albeit capacity for risk may be relatively high) and drawing down on assets is often a necessity. At this stage, hedge funds can be an integral part of a portfolio; smoothing returns and providing significant downside protection and therefore the portion invested could be higher, perhaps up to 25%.

A typical multi-manager, multi-strategy FoHF will seek to generate a return of between eight and 12% per annum (after fees) over the course of a full business cycle with volatility (risk) akin to world government bonds. As a result, investing in a broad based FoHF should be seen as a medium to long term proposition whereby investors should benefit from the power of compounding over time. This is particularly powerful when there is more emphasis on preserving capital.

All investments carry risk, not least that they can be illiquid at times. 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 monthly subscriptions 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. This supports the argument for a broadly diversified portfolio.

A common criticism of hedge funds is the issue of taxation. Many hedge funds are domiciled in offshore jurisdictions such as Bermuda and 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 (CGT). 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).

Risk profile

Investors often have difficulty assessing their risk profile. Some are prepared to take too much risk and jeopardise their retirement plan whereas others take too little and reduce the chances of achieving their long-term financial goals. A good investment adviser will take time to help a client understand the difference between financial risk tolerance - the level of risk that a client believes he or she is willing to accept (a psychological attribute) - and their risk capacity which is the extent their financial position can suffer a setback without disrupting the long-term objectives (a financial attribute).

Traditionally the risk profile within a portfolio has been decreased approaching retirement by reducing real assets such as equities and property to build the fixed interest and cash element. The wider availability of hedge funds means that a more sophisticated strategy can be deployed within a diversified portfolio as part of this risk reduction process without giving up on all the upside potential.

Hedge funds can be a useful tool at most stages in the lifecycle of retirement planning either to reduce volatility and improve compounded investment returns or as a more sophisticated risk/reward balancer for those nearing retirement.

Ben Mountain
Investment Manager
Citi Quilter