How Hedge Funds Can Fit Into Your Investment Portfolio

Hedge funds are often viewed as complex or reserved for high-net-worth investors, but they can be a useful addition to a well-diversified investment portfolio. They offer strategies that differ from traditional investments, aiming to generate returns in various market conditions. This article explains hedge funds in simple terms and explores their potential role in an investment strategy.

What Are Hedge Funds?

Hedge funds are investment funds that use a range of strategies to generate returns, including:

• Long and short positions: Buying stocks expected to rise and selling stocks expected to decline.

• Leverage: Borrowing money to increase potential returns.

• Derivatives: Using contracts like options or futures to hedge risks or speculate on price movements.

Unlike unit trusts, which typically track stock market performance, hedge funds aim to achieve positive returns even when markets decline. They are managed by professionals who use active strategies to manage risk and opportunities.

How Hedge Funds Work – An Example

Consider an investor who holds a portfolio of traditional stocks and bonds. If the stock market declines, their portfolio value drops.

Now, assume they allocate 10% of their portfolio to a hedge fund that follows a long/short strategy:

• The hedge fund buys undervalued stocks (long positions) and sells overvalued stocks (short positions).

• If the market declines, the fund’s short positions may gain in value, offsetting losses from traditional stocks.

In this way, hedge funds reduce overall risk and provide more stable returns in different market conditions.

Regulation 28 and Hedge Funds

1. Purpose of Regulation 28

• Protects retirement savings by limiting exposure to high-risk assets.

        • Encourages diversification to reduce concentration risk.

        • Ensures investments align with long-term financial stability objectives.

2. Hedge Fund Investment Limits

• Hedge funds are considered alternative investments, which fall under “Other Assets” in Regulation 28.

• Pension funds are allowed to invest up to 10% of their assets in hedge funds.

Within this 10% limit:

• 5% can be allocated to hedge funds per single issuer (i.e., an individual hedge fund).

• 10% total across multiple hedge funds to ensure diversification.

Pros and Cons of Hedge Funds

Pros

✔ Portfolio diversification: Hedge funds use alternative strategies that do not always move in the same direction as traditional investments.

✔ Risk management: Some hedge funds aim to protect against market downturns.

✔ Potential for higher returns: As hedge funds can add value in positive and negative markets,  skilled managers can potentially generate returns that outperform traditional markets.

Cons

✖ Higher fees: Hedge funds typically charge a management fee and a performance fee.

✖ Limited liquidity: Some hedge funds have lock-in periods before investors can withdraw funds.

✖ Complexity: Strategies can be difficult to understand and require due diligence.

Where Hedge Funds Fit in an Investment Portfolio

Hedge funds should not replace traditional investments but can complement them. A balanced portfolio might include:

• 60% Stocks and bonds (traditional investments for growth and stability).

• 30% Alternative investments (such as private equity or real estate).

• 10% Hedge funds (for risk management and diversification).

This allocation should not be interpreted as advice but rather as an illustration. Investment allocation depends on risk tolerance, investment goals, and market conditions.

In Conclusion

Hedge funds are not for every investor, but they can be a valuable tool when used correctly. Their ability to manage risk and generate returns in various conditions makes them a useful option for those looking to diversify beyond traditional investments.

Before investing, it is important to assess your risk tolerance, investment objectives, and the specific hedge fund strategy. If you need guidance on incorporating hedge funds into your portfolio, consider speaking with a financial adviser to determine the best approach for your needs.

Disclaimer: This article is for informational purposes only and should not be considered financial advice. For personalised investment advice tailored to your specific financial situation, please contact us or one of our qualified financial advisers at Corona Financial Services.