Improving pension fund outcomes – A case for hedge funds


What is regulation 28?


“You may have seen that asset managers classify some of their multi-asset unit trust funds as being Regulation 28 compliant. This is an important distinction for investors who are saving towards retirement and want to ensure that their investment is not overly risky. Regulation 28 is part of the Pensions Fund Act and aims to ensure that individuals’ hard-earned savings are invested in a sensible way and protected from poorly diversified portfolios. The underlying portfolios of RAs and Regulation 28-compliant unit trusts are limited to exposures of 75% in equities, whether in South Africa or abroad, 25% in local or international property, 25% in foreign investments, excluding Africa, and 5% in Africa (outside South Africa) of the total capital invested.” Quoted from Prudential Investment Managers

In 2018, regulation 28 of the pension fund act was amended to allow for further exposure to offshore assets. The table below shows the amendments to regulation 28 which took place in 2018.


Regulation 28 Maximum Limits Pre 2018 Amendment Regulation 28 Maximum Limits Post 2018 Amendment
Equity 75% 75%
Listed Property 25% 25%
Offshore Assets ex-Africa 25% 30%
Africa ex-sa Assets 5% 10%
Alternative Assets – Hedge Fund 10% 10%
Commodities 10% 10%


A welcome change was to the offshore ex-Africa limits which increased from 25% to 30%. The allocation to Africa ex-SA was also increased from 5% to 10%.

The added allocation to Africa ex-SA is incongruous given what is trying to be achieved, which is risk management. Africa ex-SA is notorious for the risks which are commonly associated with it. To put this into perspective, as of the end of August 2020, the South African equity market constituted 88.74% of the MSCI Emerging Frontier Markets Africa Index. In other words, Africa ex-SA is roughly one tenth of the size of the South African market. This begs the question as to why a 10% allocation would be appropriate given the objective of regulation 28.

Pie Chart of Country Weights


The local vs offshore debate


Its unsurprising that regulation 28 compliant funds have performed poorly over the past 5 years given the return from South African asset classes such as equities. The graph below shows the performance of the ALSI (South African stock market) compared to that of the S&P500 index (a US equity index) over a 5-year period ending March 2019.

Graph comparing local and offshore equity markets

This has led to the debate as to whether or not the regulation 28 offshore limit of 30% is in fact appropriate.

Traditionally South African equities have been strong performers. The graph below shows the performance of the ALSI compared to the S&P500, from December 2001 to November 2018.

We can clearly see which market was the outperformer over that period.

Graph comparing local and offshore equity markets 2

Let’s put this into perspective. We see from the above graph that the local market outperformed the S&P 500 over a 17-year period.

The graph below shows the 5-year market return of both the ALSI and the S&P 500 from January 1997 to November 2001. During this period the South African stock market meaningfully underperformed the S&P500. This is not to indifferent from what we are experiencing today.

Graph comparing local and offshore equity markets 3

In light of historical data, the question that investment professionals are asking is in relation to how different the investment landscape is both locally and offshore and whether history will repeat itself? i.e. will the local market start to outperform the now expensive S&P 500 index.


The great South African exodus: Is this time different?


Without dwelling on all the things that we have failed to do correctly as a country over the past decade, lets simply highlight what we know from a market and economic perspective.

Economically one may be forgiven for thinking that this time is different. Be it our ability to keep the lights on, control our debt to GDP, generate business confidence, or successfully allocate capital to infrastructure, we have seen a systemic deterioration in many areas of the South African economy. This is not to say that the nail is in the coffin but rather to highlight the fact that we have serious headwinds which we need to address over a 10 – 15 year period. There is no quick fix.

From a stock market perspective, we are fortunate that the majority of the earning from South African listed companies are in fact derived from offshore operations. These companies are commonly referred to as “Rand Hedged” stocks. Stocks such as British American Tobacco. Unfortunately, they have not been the saving grace for South African investors over the past 5 years despite their foreign earnings. Nevertheless, these companies offer an alternative to SA Inc. stocks, which are companies that are traditionally reliant on the South African economy and or consumer. An example of a SA Inc stock is Telkom.

Where does this leave us? Well the South African stock market is largely independent from the South African economy by way of its foreign earnings. Despite the poor performance over the past 5 years, South African investors can at least gain some degree of comfort around the fact that regulation 28 funds can access the offshore market via these rand hedge companies.

How meaningful is that going to be going forward with such a limited number of shares to choose from?


Are rand hedged stocks enough to protect investors from the South African centric risk factors?


Largely speaking, one could say that it is more than likely that our rand hedged stocks, along with an offshore allocation of up to 30% offshore exposure could be enough to protect South African investors from the South African centric risk factors of which there are many.

Let’s however take this idea one step further.

According to JSE’s director of Issuer Regulation John Burke, “in 1998, there were 669 companies listed on the JSE. By 2004, this number had dropped to 396.” According to an article titled “How the JSE has changed over the past decade” by Hilton Tarrant, the number of listed companies on the South African stock market appears to have shrunk by around 42% from 1998 to 2017.

One debate is to say that the remaining companies allow for a selection of better and perhaps more robust companies to choose from. The other debate is to point out that the pool of stocks on the South African stock market is shrinking for better or worse. The worry is that if this trend were to continue in a meaningful way, where could that leave the earnings diversification on the South African stock market?

The chart below shows how the composition of the South African stock market has changed over time. The middle column labeled “ZAR Hedge” refers to rand hedged stocks (excluding resource stocks) within the broader market. In January 2006, 16% of the local market was comprised of rand hedged stocks (excluding resource stocks) compared to the 39% as of April 2020.

JSE all Share Index Graph

One can make the case that over a long period of time, 10 – 15 years, the South African market has enough diversification whereby a portion of the companies should be resilient enough to grow their earnings be it from offshore or local operations, leading to growth over time. This coupled with the 30% offshore allocation could be enough to for asset managers to successfully deliver inflation beating returns over the longer term.

This unfortunately doesn’t help investors who are forced to be constrained to regulation 28 during the periods where greater flexibility may be required.

The argument around rand hedged stocks as an indirect offshore diversification tool within regulation 28 (excluding the additional 30% direct offshore allocation) does arguably have some merit to it however, it’s hard to see how such a relatively small pool of stocks can offer asset managers enough of a selection to these companies without having to pick from the most promising of the lot.

The chart below shows that approximately 50% of the local stock market is comprised of 4 companies. Naspers and Prosus are viewed as one company. Although these companies are considered as rand hedged companies along with the like of British American Tobacco, Anglo Gold, Mondi and Gold Fields, they form such a large part of the index and at time they may be less investable than one can afford to sell in a portfolio.

Weight of largest shares over time

This debate touches on the issue of large vs boutique managers and their ability to generate alpha over time. Without debating the merits of both sides, one can conclude that over the long-term the size of a manager should hamper their ability to deliver good returns however, smaller managers who are more nimble and who can trade their portfolio more actively do seem to have an advantage in the short-term given the size and concentration of our rand hedge stocks.

The difficulty is in finding the balance between large and boutique managers.


What does the research say about offshore exposure?


There are many views around what the optimal offshore exposure should be for a South African investor. The answer can understandably be different from one individual to another. The efficient frontier graph shown below suggests that based on the data since 1950, a 30% offshore exposure can help to reduce long-term risk whilst increasing long-term return.

The purple dot shows that further offshore exposure can continue to reduce the risk and increase the return of a portfolio. The blue dot shows the point at which even more offshore exposure can yield the same risk at a higher return than the 30% exposure mark.

Could this suggest that the 30% offshore allocation in regulation 28 is in fact fundamentally flawed?

line graph showing Risk/return frontier since 1950

It’s no secret that the South African market has little exposure to companies which are leading the way in global development in one field or another. Other than Naspers/Prosus the South African stock market has limited exposure to the global technology sector. Nor does Africa ex-SA have such exposure!

The graph below shows the world’s 60 most innovative economies of which South Africa is ranked 50th. This puts us in the bottom 20% and with deteriorating economic fundamentals what does this mean for our economy and for those trying to protect their retirement savings in a regulation 28 vehicle.

Map Chart showing the worlds 60 most innovative counties

A Ninety One article by Paul Hutchinson titled “How to invest offshore” discusses the regulation 28 conundrum. The chart below suggests that for an investor who is looking for a high return over a 3 year investment horizon, requires a higher exposure to offshore assets. This is not dissimilar to the efficient frontier graph on page 5.

Optimal blend for a 3 year investment horizon

According to Paul Hutchinson “Therefore, a Regulation 28-compliant multi-asset high-equity or other domestic fund that is limited to 30% offshore exposure, may not be the most efficient solution. In fact, an unconstrained investment mandate improves the return characteristics of a multi-asset (balanced) portfolio at only marginally higher risk.”

The disadvantage of increasing one’s offshore exposure beyond the 30% mark is that it can add to an increase in volatility as a result of the fluctuations in the rand. This may be an issue for investors who have a more conservative risk profile and who require a high degree of income in local currency.

Investors tend to react to the rand in any case. When the rand weakens on poor sentiment as it has done so many times in the past, investors tend to want more offshore exposure at a time when it’s probably unsuitable to increase one’s offshore exposure due to various factors such as an already weak currency and a local market that has probably already fallen in value.

It stands to reason that if investors have a health exposure to offshore assets (excluding rand hedged stocks) they may be less inclined to want to react to a devaluing currency or deteriorating fundamentals in the local economy. Investors who tend to want more offshore exposure, inherently have concerns around the local economy and the local market. What’s appropriate for them may be contrary to what is allowed in a regulation 28 portfolio.


What are we to do?


The is how to achieve greater flexibility within a regulation 28 portfolio. Until such time as the regulator decides to change the limitation to offshore assets, we need to work within the constraints of the pension fund regulations.

The solution could be found in the 10% allowable allocation to hedge funds.

In 2015 new regulations allowed for hedge funds to fall under the CISCA (Collective Investments Schemes Control Act) and be formally registered as collective investment schemes alongside traditional regulation 28 funds.

The new regulation allowed for greater transparency, liquidity, and risk control measures than was required in the past.

“CISCA offers more transparency, better investor protection and will show the investing public that the vast majority of hedge funds in South Africa are actually conservatively managed and well diversified, use moderate leverage and serve to reduce investment risk. Hedge funds have been widely misunderstood and there is an education gap that needs to be filled. I suspect this may take some time though and that the big inflows into the industry may only happen over the medium to longer term.” Mark Preston COO, Laurium Capital, July 2015.

Hedge funds have operated in the new regulatory environment for 5 years with some managers seeing stable growth in their assets undermanagement. Independent ratings on South African hedge funds have however remained hard to come by. For financial advisers and investors alike, the safety net of having independently rated funds within a portfolio can add to a more robust investment process with additional checks and balances. Independent ratings are available for select long-only funds. For financial services providers who utilize

independent ratings agencies in their investment selection process, additional inhouse research is required to understand how select hedge fund managers can integrate into their additional checks and balances processes.

With the increase in popularity, hedge funds are likely to be covered by independent ratings agencies in the future. The sooner that this happens the better it will be for the industry and more importantly the end investor.

An article by Tumi Loate, Investment Analyst at 36ONE Asset Management titled “Achieving balance is not as easy as 60/40” discusses how alternative asset classes can offer value in an environment where the risks to a traditional 60/40 portfolio (representative of a multi-asset balanced fund) are structurally higher with the issues facing the South African economy.

She argues “As South Africans can invest globally, it is clear that if investors are to generate decent returns at moderate risk levels going forward, they will need to be adaptable and adjust their portfolio to the market’s peaks and valleys. While historical performance can be analysed, one should be careful not to slavishly follow allocations where the logic is based on a time past. A well-diversified portfolio should feature liquid alternatives. Combined with bonds and equities, these are able to complete the job of providing income, growth and protection against inflation and equity market fluctuations. Alternatives such as commodities and equity long/short hedge funds offer uncorrelated returns which can help to mitigate against large drawdowns in equity markets.

Equity long/short hedge funds have historically outperformed traditional long only equity funds with lower risk as measured by standard deviation of returns. Not only do the Sharpe ratios indicate a vastly better result, a positive skew can be observed when assessing the historical returns of the top quartile funds. Extreme returns generally happen on the upside as opposed to the downside – an advantageous characteristic when considering catastrophic risk. These funds are able to produce positive returns in both rising and falling equity markets (due to their combination of long and short positions and protective structures) and therefore have the ability to produce asymmetrical returns, which is especially valuable in times of heightened uncertainty.”


What does the evidence show?


In order to understand if hedge funds can improve the outcome within a regulation 28 portfolio, we need to first see what the numbers suggest.

As a starting point one needs to select 4 hedge funds with long-term track records. Each of which can receive an allocation of 2.5% to maximise the 10% allocation for a regulation 28 portfolio.

The 4 hedge funds we selected were based on the following points:

  • A long-term track record with transparent data.
  • Stable investment team.
  • They offer a retail class of hedge fund.
  • The funds needed a reasonable degree of assets under management.
  • They are independently rated on their long only unit trust funds which have the same management team that runs their hedge funds along the same process. We feel this adds credibility to their investment team, business model and research capabilities.

The next step was to select an independently rated long only multi-asset balanced fund with a long-term track record. This fund will represent the remaining 90% of the regulation 28 portfolio, which can later be amended to include other multi-asset balanced funds. We note that Balanced Fund A is the largest multi-asset balanced fund in South Africa which is highly rated and has achieved a real return of around 8-9% per year since its inception in the late 1990s. We therefore give ourselves a highly competitive benchmark which we need to improve on through the use of hedge funds with small exposures at 2.5% per hedge fund.

The graph below shows the comparative performance of the respective funds since October 2008 to July 2020.

Graph of Comparitive Performance

Source: API research

The chart below shows the “Hedge Only Portfolio” which represents an equally weighted portfolio comprising on the 4 chosen hedge funds, against Balanced Fund A. The performance of the “90/10 Portfolio” is also included for comparative purposes.

Graph of Comparitive Performance 2

The Correlation matrix table below shows the correlation between the respective Funds. We can see that Hedge Fund B has a high correlation with Balanced Fund A, while Hedge Fund C and D have a negative correlation with Balanced Fund A. Hedge Fund A has a moderate correlation with Balanced Fund A.

Blended Portfolio

Source: Statistical Analysis by Matrix Asset Management

The graph below shows the performance of the portfolio from December 2009 to May 2020.

Graph of portfolio unit price over time.

Source: Statistical Analysis by Matrix Asset Management

The 90/10 portfolio which is represented by the green line, has improved the return of the portfolio over and above that of Balanced Fund A.

The performance table below shows the performance of the respective funds as well as the 90/10 portfolio. We can see that the 90/10 portfolio outperforms that of Balanced Fund A.

Graph of portfolio unit price over time.

Source: Statistical Analysis by Matrix Asset Management
What about the risks?

The chart below shows the annualised return of the respective funds compared to the measure of risk (Standard Deviation). We can see how the 90/10 portfolio achieves a higher return with a lower degree of risk compared to Balanced Fund A.

Graph of Annualized return vs anualized standard deviation

Source: Statistical Analysis by Matrix Asset Management

The evidence therefore suggests that the select hedge funds can increase performance whilst reducing risk within a regulation 28 portfolio.


What could one argue against the evidence?

Criticism 1

The quantitative analysis has shown that the portfolio of hedge funds can increase the return whilst reducing the risk. However, the improvement in the return over the period of December 2009 to May 2020, the 90/10 portfolio had an annualised return of 0.28% more than Balanced Fund A. This seems like a very modest increase in the added return over the long-term.

Counter argument

The comparative performance chart on page 8 shows the return of the Hedge Fund Portfolio compared to Balanced Fund A. The added annualised return of 0.28% over the long-term may seem fairly modest however, the performance attribution is restricted by regulation 28’s maximum exposure of 10% towards hedge funds. Despite the modest added return over the period, the 90/10 portfolio also reduces the volatility of the portfolio. Both of these variables contribute to the argument for the inclusion of hedge funds in a regulation 28 portfolio.

Over the short-term the hedge funds have meaningfully increased the return of the 90/10 portfolio as well as meaningfully reducing the volatility. Over the 3-year period ending May 2020, the 90/10 portfolio outperformed Balanced Fund A by 0.81% per annum.

Criticism 2

Past performance is not a guarantee of future performance. What if the hedge funds were selectively picked to support the argument for including hedge funds in a reg 28 portfolio?

Counter argument

Each hedge fund follows its own unique investment style and philosophy. Two of the four hedge funds typically have a strong performance during a bull market whilst the remaining two are run more conservatively. In other words, each hedge fund has its own unique attributes which contribute to the portfolio in some way which isn’t necessarily through a much higher return.

There is no guarantee that all of the hedge funds will be able to protect on the downside. However, the combination of the four hedge funds allows for downside diversification.

The graphs below show the monthly returns of the various hedge funds compared to Balanced Fund A. The periods which are highlighted in green represent periods of volatility in the market where the hedge funds successfully protected on the downside while the periods in red represent periods where the hedge funds added to the downside volatility.

The periods in purple represent periods where the hedge funds and Balanced Fund A have a similar downside profile. During these periods the hedge funds neither added to nor did they protect on the downside.

Hedge Fund A

Source: API research

Hedge Fund B

Source: API research

Hedge Fund C

Source: API research

Hedge Fund D

Source: API research

During the 2020 market crash, three of the four hedge funds successfully protected on the downside whilst Hedge Fund B had a similar return profile to Balanced Fund A.

During the global financial crisis of 2008-2009 two of the hedge funds protected on the downside whilst one of them added to the downside and the other neither added to nor did it protect on the downside.

If one were to selectively pick the best performing hedge funds over the last 10-14 years, both hedge fund B and C would likely be replaced with higher returning alternatives which may or may not further reduce the risk to the portfolio.

Rather than creating the best performing hedge fund portfolio with the benefit of hindsight, we elected to use hedge funds with different characteristics which add to the alpha generation (active return) over a long-term period. Our selection was also restricted to hedge funds which met the criteria as stated on page 7.

Criticism 3

Hedge funds are known for being expensive. Costs are a known detractor to performance.

Counter argument

Hedge funds are expensive when compared to long only funds on a relative basis however, what matters is the net performance – performance after all costs. Assuming that both funds carry the same risk profile, fund ABC may charge a fee which is twice that of fund XYZ however, its net performance over a 7-year period is higher than that of fund XYZ.

Hedge funds are typically much smaller than the average long only fund, they therefore are not able to scale their costs as easily as cheaper long only funds. Hedge funds can also tend to trade more than long only funds which increases their costs.

Over the short-term an underperforming hedge fund with a high cost will certainly feel like a detractor in the portfolio compared to cheaper long-only funds. In order to get the desired net performance (performance after all costs) investors need to give the hedge fund manager enough time to add value.

The industry does however need to increase its benchmarks which are typically cash type benchmarks. For a manager to generate a performance fee for outperforming cash does seem questionable. A possible solution is to increase the base fee of the hedge funds and set a higher benchmark with performance fees. Lets hope that the industry adapts to this principle.

Criticism 4

Are hedge funds only being considered at this point in time on the back of recent poor performance from long only, regulation 28 funds?

Counter argument

The long period of underperforming multi-asset funds has led to many investors switching to cash or fixed income funds, therefore abandoning their long-term financial planning. This has naturally led to the industry attempting to find alternative means of generating returns for their clients.

Regulation 28 has come under much criticism over the past several years as the restrictions haven’t helped long term investors. The threats by the government to use pension money to fund infrastructure development and other state run initiatives, has caused investors to want to externalise more than 30% of their pension fund in an attempt to protect it from the poor returns from the local market. Regulation 28 may be amended to allow for further flexibility at some point in the future however, we need to work within the current constraints. This has led to the question around hedge funds and their inclusion in regulation 28 portfolios.


If hedge funds outperform balanced long only funds with the same degree of risk or less, then this suggests that investors should have a higher exposure to hedge funds than long only balanced funds.

Counter argument

The efficient frontier for hedge fund B, C and D suggests that the optimal exposure to those hedge funds could be as high as 60%. Although it is unlikely that the average investor will feel comfortable with 60% exposure to hedge funds, the numbers do suggest that they can form a larger part of an investor’s portfolio.

Investors don’t need to commit such a large portion of their portfolio to hedge funds in order to generate real returns over the long term. For the average investor who has no allocation to hedge funds, a 10% – 20% allocation can make a meaningful difference to their portfolio.

Long only funds have underperformed for a 5-year period which could cause some investors to change their investment strategy to include less exposure to underperforming long only funds such as Balanced Fund A, in favour of hedge funds. Investors must be mindful that the underperformance from long only funds and multi-asset long only funds in particular, won’t last indefinitely. Rather than loading one’s portfolio with hedge funds in excess of 50% exposure, investors should rather use hedge funds to optimise the risk and return characteristics of their portfolios over a full market cycle (from boom to bust).


Additional Charts



Hedge Fund A


Hedge Fund A Efficient Frontier


Percentage Invested
in Hedge Fund A
Portfolio Standard
Portfolio Expected
0,00% 7,42% 9,81%
10,00% 7,77% 10,44%
20,00% 8,20% 11,06%
30,00% 8,69% 11,68%
40,00% 9,23% 12,30%
50,00% 9,83% 12,92%
60,00% 10,46% 13,54%
70,00% 11,12% 14,17%
80,00% 11,81% 14,79%
90,00% 12,52% 15,41%
100,00% 13,25% 16,03%


Hedge Fund A Performance Chart

Hedge Fund A Monthly Comparitive performance

Hedge Fund A Monthly Comparitive performance 2

Hedge Fund B

Hedge Fund B Efficient Frontier


Percentage Invested
in Hedge Fund B
Portfolio Standard
Portfolio Expected
0,00% 6,90% 8,33%
10,00% 6,59% 8,44%
20,00% 6,32% 8,54%
30,00% 6,10% 8,65%
40,00% 5,95% 8,76%
50,00% 5,85% 8,87%
60,00% 5,82% 8,98%
70,00% 5,86% 9,09%
80,00% 5,97% 9,20%
90,00% 6,13% 9,31%
100,00% 6,36% 9,42%


Hedge Fund B Performance Chart

Hedge Fund B Monthly Comparitive performance

Hedge Fund B Monthly Comparitive performance 2

Hedge Fund C

Hedge Fund C Efficient Frontier


Percentage Invested
in Hedge Fund C
Portfolio Standard
Portfolio Expected
0,00% 8,44% 12,09%
10,00% 7,46% 11,69%
20,00% 6,57% 11,30%
30,00% 5,82% 10,90%
40,00% 5,26% 10,50%
50,00% 4,96% 10,11%
60,00% 4,97% 9,71%
70,00% 5,28% 9,31%
80,00% 5,84% 8,91%
90,00% 6,60% 8,52%
100,00% 7,49% 8,12%


Hedge Fund C Performance Chart

Hedge Fund C Monthly Comparitive performance

Hedge Fund C Monthly Comparitive performance 2

Hedge Fund D

Hedge Fund D Efficient Frontier


Percentage Invested
in Hedge Fund D
Portfolio Standard
Portfolio Expected
0,00% 12,33% 14,40%
10,00% 10,83% 14,01%
20,00% 9,37% 13,63%
30,00% 8,00% 13,24%
40,00% 6,77% 12,85%
50,00% 5,76% 12,46%
60,00% 5,10% 12,08%
70,00% 4,95% 11,69%
80,00% 5,34% 11,30%
90,00% 6,18% 10,91%
100,00% 7,30% 10,52%


Hedge Fund D Performance Chart

Hedge Fund D Monthly Comparitive performance

Hedge Fund D Monthly Comparitive performance 2


This document is intended for information purposes only and none of the information contained herein constitutes investment advice or a recommendation, solicitation or offer by Asset Protection International (Pty) Ltd (“API”) to buy or sell any financial product. The information contained in this presentation has been prepared without consideration of the investment objectives, financial situation, or particular needs of any particular recipient. Any investments mentioned in this document may give rise to substantial risk, including the possible loss of principal value, and are not necessarily suitable for all investors. This presentation should accordingly not be considered as a substitute for the exercise of your own judgment or for obtaining independent advice based on your personal requirements and circumstances. Although all precautions have been made to ensure reliability of data and information contained herein, API cannot guarantee the reliability thereof.

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