Is there room for it in your retirement planning?

By Deidré Valentine

6/5/2023

The long debate about Regulation 28 and its limitations on pension funds, particularly the majority exposure to South African assets, has been partially put to rest after the South African Reserve Bank announced in February 2022 that pension funds may now have up to 45% exposure to foreign investments.

This gives investors greater flexibility to move their exposure between South African and foreign assets. However, whether it is the right time to necessarily have maximum exposure to foreign assets is a discussion for another day.

In this article, I want to look at the concept of downside protection for investors (especially retired investors), which in my opinion is more important than flexibility in terms of exposure between South African and foreign assets.

Downside protection is a strategy to hedge the risk of (downward) volatility and reduce or eliminate future losses for the underlying portfolio.

For investors, risk is the possibility of permanent capital loss. The primary concern for pre-retirement investors lies not in volatility alone, but in the potential for relative losses that hinder adequate portfolio growth. Volatility can have a more significant impact on retired investors as their monthly income is often derived from investments, resulting in the realisation of losses or gains.

Conventional unit trusts that most investors are familiar with, known as “long only” investments, have limitations when it comes to hedging. It can only profit when the market rises but provides minimal to no safeguards against market downturns. Therefore, investors often flee to cash when they get restless about the markets, as cash often has minimal risk of an absolute loss.

However, the issue of relative losses is a problem here as cash as an asset class struggles to outperform inflation over long periods of time, which means that investors suffer losses in relative terms.

This places investors in a complex situation where striking a balance becomes crucial: they need sufficient exposure to growth assets to outpace inflation in the long run, ensuring their money lasts throughout retirement, while simultaneously minimising portfolio volatility and the risk of negative returns.

Is there a solution to this problem?

Hedge funds can profit from both market downturns and upswings. They stand apart from traditional unit trust funds due to their ability to leverage borrowed funds for larger investments, utilise derivatives, and engage in short sales.

The benefit of this is that hedge funds typically outperform equity and balanced funds when the market is underperforming. The downside is that hedge funds struggle to outperform equity funds in periods when the market is rising.

Investors should therefore consider whether higher returns during market rises are more important to them than limiting possible losses.

The South African hedge fund industry grew by 30% from December 2021 (R86.9 billion) to December 2022 (R113 billion). Further changes to Regulation 28 in 2023 now allow pension fund investors to allocate up to 10% of their exposure to hedge funds.

Despite the perception of hedge funds being inherently risky, it is important to reassess our perspective and reconsider how we approach these investment vehicles.

Do your homework

I’m not implying that hedge funds are devoid of risks. It is crucial to conduct thorough research and analysis on the following matters:

• The fund manager and the investment team’s experience;
• Historical returns (although this is not necessarily an indication of future returns);
• Understand the risk of the fund by examining ratios such as the Sharpe, Sortino and Standard deviations and comparing them to those of other funds; and
• Although hedge funds may incur higher investment management fees at times, it is crucial to assess the returns after deducting fees and compare them to those of balanced funds.

Example

Returning to my point regarding portfolio volatility and negative returns, I would like to illustrate the following using a highly simplified example:

Retired investors often place their portfolio in a balanced mandate, with around 60% exposure to growth assets (equities and property) and 40% exposure to conservative assets (bonds and cash), in order to reduce the volatility of the portfolio.

The advantage of a living annuity is the absence of restrictions on allocating funds to hedge funds or alternative asset classes.

In the table provided below, I aim to demonstrate the impact on portfolio returns and volatility downturns over a five-year period (from 31 March 2018 to 31 March 2023) as the allocation to hedge funds is progressively increased. A downturn is usually measured by calculating the percentage difference between the highest and lowest values of an investment.

In the example, I divide the allocation to hedge funds equally between two of the best-known hedge funds in South Africa.

The table clearly illustrates that as the allocation to hedge funds increases, returns improve, while volatility and downturns decrease.

I’m not saying that the allocation to hedge funds is the only reason for the result, but it is something to note.

Sequence risk refers to the risk that the timing of withdrawals from a living annuity can adversely affect an investor’s annual returns. Withdrawing funds during a bear market has a more pronounced negative impact compared to withdrawals during a bull market. For instance, if an investor withdraws 5% of their initial portfolio value each year, a 50% downturn implies that the initial 5% withdrawal now represents 10% of the portfolio’s current value.

Consequently, when markets eventually rebound, there is substantially less capital available from which an income can be drawn.

A diversified portfolio, with lower volatility, can protect a portfolio against sequence risk.

In the end, it is important to thoroughly address all aspects of retirement planning, such as volatility, growth, capital preservation, tax considerations, and portfolio construction, in collaboration with an advisor. This ensures that your overall planning is as efficient as possible and grants you the peace of mind to retire one day (or now).

The consideration of hedge funds will be part of this planning process but should not be the main consideration.

Deidre Valentine is a certified financial planner and wealth manager at Woodland Wealth. Contact her at info@woodlandwealth.co.za.

Although all possible care has been taken in the preparation of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone who intends to take any financial action based on this document is strongly advised to first consult with his/her personal financial advisor. Woodland Wealth is an authorised financial service provider with FSP no. 5966.