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By Ruan Breed*
The trial in New York of celebrated crypto ‘genius’ Sam Bankman-Fried is laying bare the extent of the fraud involved in his crypto hedge fund Alameda Research. The audacity of the fraud is hopefully striking enough for ordinary investors to realise that this was an exceptional case and that not all hedge funds are designed to steal billions of dollars.
Sadly, hedge funds have developed a dubious reputation in some circles because of scandals such as these, and debates about the higher fees they command.
However, not all hedge funds are fraudulent or risky. In fact, they can form an important part of your long-term investment strategy especially as Regulation 28 allows you 10% allocation to hedge funds.
The case for hedge funds in your investment portfolio
Contrary to popular belief, hedge funds aren’t just for the ultra-rich. They offer a stronger and deeper diversification than traditional assets because hedge fund managers can use non-listed, alternative instruments in their strategy.
In an ideal world, this will result in you seeing positive returns from these assets when traditional markets turn negative or the economy is performing poorly.
Understanding how hedge funds work
Hedge funds pool capital from multiple investors to invest in a variety of assets. They are managed by professional fund managers who use different strategies to generate strong returns – sometimes considerably higher than traditional assets, but also with higher risk.
They are able to execute these alternative strategies because hedge funds have more flexibility in the types of assets they can invest in. Typically, this mix will include equities, bonds, derivatives, and other financial instruments.
Potential benefits of hedge funds
The case to include hedge funds in your portfolio will become clearer once you understand their role in your long-term strategy. This will depend from one person to the next, although there are clear benefits you should know about:
Diversification: Hedge funds can invest in both financial and non-financial markets and are properly equipped to take positions in a much broader range of investment opportunities. These opportunities generally look to further diversify your exposure beyond your traditional portfolio.
Asymmetry: Hedge funds often seek lower volatility of returns by achieving a certain level of positive asymmetry. Asymmetric investing means that the probability for upside is greater than the downside.
Quality return: Over the past 20 years hedge funds have provided an equal or higher-quality return relative to equities, as well as the 60/40 blend of equities and bonds.
Hedge fund strategies
Unlike traditional fund managers, their hedge fund counterparts have a wider range of assets and strategies they can use to optimise returns. These are some of the more common strategies they employ:
- Global macro strategies: Managers make bets based on major global macroeconomic trends
- Directional hedge fund strategies: Managers bet on the directional moves of the market
- Event-driven hedge fund strategies: Managers find investment opportunities in corporate transactions
- Relative value arbitrage strategies: Managers take advantage of relative price discrepancies between different securities
- Long/short strategies: Managers make what are known as ‘pair trades’ to bet on two securities in the same industry
- Capital structure strategies: Some hedge funds take advantage of the mispricing of securities up and down the capital structure of one single company
Hedge funds and your retirement savings
You might not be aware that you can get tax benefits from investing in a hedge fund in the same way you do in any Regulation 28 fund.
Reg. 28 stipulates the type of assets you can invest in, and how much of your portfolio may be dedicated to these asset classes. The reason for this is to prevent over-exposure to certain investments that may place your long-term savings at risk.
However, Reg. 28 allows you to allocate up to 10% of your total retirement portfolio to hedge funds.
Whether you want to or should maximise this 10% exposure is a decision that you should make together with your financial advisor. These instruments aren’t suitable for every investor, so do your homework and consult with a professional advisor to make an informed decision.
In summary, the hedge fund industry might have its share of risks and controversies, it also offers unique benefits and opportunities for diversification, especially for long-term investors. With proper understanding and careful selection, hedge funds can be a valuable addition to your investment portfolio.
* Ruan Breed is a financial advisor at Brenthurst Stellenbosch and George [email protected]
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