The A to Z of alternatives in your retirement journey

15 May 2024 | Personal Finance, Uncategorised

You can now invest up to 15% in private markets and 10% in hedge funds within South African retirement funds. This follows international trends, where it’s relatively commonplace for retirement funds to invest over 10% in alternative assets. While the regulation changes pertain to pre-retirement portfolios, alternative investments present a significant opportunity for both pre- and post-retirement portfolios, due to alternatives’ illiquidity premium and their uncorrelated return profile.

The A to Z of alternatives

Alternative investments are non-traditional investments (i.e. they are not traded on a stock exchange or are not traditional instrument buy-and-hold strategies). Some types of alternative assets include:

Private equity funds: Investors purchase shares in privately held businesses, usually with the goal to improve operations, increase value, and, eventually, to exit the investment at a profit. These funds pool money from pension funds, endowments, high-net-worth-individuals, institutional investors, corporations, and governments to invest in private companies. Private equity funds aim to actively manage and grow a company to generate high returns. These funds are illiquid and have a fixed term (typically 7-10 years).
Private debt funds: These funds specialise in lending money to private companies to generate capital or investment income. Like any debt instrument, any money borrowed from the funds is repaid with interest added to it. These funds can be fixed term but may also have open-ended structures which offer investors a degree of liquidity.
Hedge Funds: These pool capital from accredited individuals or institutional investors, employing strategies like leveraging, short-selling and derivatives trading to generate returns. They ‘hedge’ against market risks, aiming to consistently achieve positive returns.

The benefits of alternative assets

Higher returns: As private market assets are not listed, they’re less liquid; you cannot sell them as easily, so you can effectively ‘demand’ a higher return from your investment. Investments in the private market space can typically be expected to deliver higher returns than public funds.
Diversified risk: With private equity and private debt investments, you’re also usually extending smaller amounts to smaller companies, which amplifies your localised economic exposure, but lessening your exposure to high-level, broader international market movements and macroeconomic events. You’re investing in something uncorrelated with everything else within your portfolio – this diversifies your portfolio and brings down your overall risk. However, there is still a risk that comes from investing in smaller, unlisted businesses, which is why due diligence is key.
Benefits pre- and post-retirement: It’s critical to consider your time horizon. Alternatives can either be open-ended funds, which are similar to a collective investment scheme, giving you some discretion as to when you can access your money; or closed-ended funds, which have a fixed term, so you can’t access your funds for a set period. Private equity funds tend to be closed-ended, whereas private credit comprises multiple fund types, presenting more liquidity options.

Pre-retirement: Alternative assets present a particularly strong prospect for the pre-retirement space, for someone with a 30-to-40-year investment horizon. Here, you can afford to take on closed-ended options as you have time on your side and less immediate liquidity requirements.

Post-retirement: In the post-retirement space, alternative assets bring you their correlation benefit to help manage your portfolio overall risk. As a retiree, if you withdraw your capital during a market downturn, you’ll have less capital invested when the markets recover – and you’ll struggle to make up that deficit. However, alternatives’ correlation benefit means your portfolio should have a lower correlation to the market during downswings, protecting the overall capital value of your portfolio during these periods. If you’re invested in open-ended funds, you then still have the option to access some liquidity, while still capitalising on the correlation benefit.

Inflation protection: Private credit often comprises floating rate loans, which move in tandem with the level of interest rates in a country. During times of high inflation, the Reserve Bank hikes interest rates to try to bring inflation down. High interest rates are a headwind for markets, so bond markets may suffer in terms of capital value and equity markets could slow down, but private credit funds work more on an accrual basis. So, they can actually benefit from a higher interest rate, with rising returns.

Private equity gives you the benefit of businesses you’re invested in being able to pass on inflationary price increases. Additionally, they don’t necessarily reprice daily as listed investments do, so you are more insulated from the day-to-day market volatility that can be driven by changing inflation expectations.

Fund manager selection is critical here as company valuations can be negatively impacted by higher interest rates. If you blend a private equity manager with a private credit manager using floating rate interest, you can ‘balance’ the negative valuation with the interest-side benefit.

Doing good: With alternative investments, your money tends to flow through to SMEs more frequently. SMEs are pivotal economic players, tending to be the collective largest employer in most nations. Additionally, you can invest to drive impact, by choosing to support specific causes such as renewable energy or infrastructure development. For example, the Resilient Investment Fund managed by Sanlam Alternative Investments targets entrepreneurs and small to medium-sized enterprises (SMEs) focussed on addressing key societal issues and the Sustainable Infrastructure Fund seeks to boost infrastructure investment by collaborating with corporate and industrial sponsors. Importantly, by supporting a private equity fund, through a trusted multi-manager, you get a lot more ‘say’ in how a business is run, which can make the potential for impact more tangible.

Choosing the right team

Due diligence is critical in the alternatives space as you’re working with unlisted and comparatively less regulated assets. When choosing a fund management team, consider:

How thoroughly they conduct due diligence before they invest;
How long they’ve operated in this space, how many funds they’ve launched, and their track record in running these funds;
Investors experience within the fund;
And the company structure. This is key. Remember, you’re ‘locking’ in your money for the long term in a closed-ended fund, so you want to be sure the same trusted team will be managing your funds for the full term of the fund. That means company turnover plays a big part. Ideally, you want to know people are prioritised and high performance is incentivised.

The risks

In the alternatives space there’s no market beta; with public funds, if the market goes up, so too, typically, do the funds. Alternative assets don’t ‘swing’ with the market; rather, they’re reliant on how the fund manager performs. So, it’s critical to select a fund manager with the requisite skill and expertise, which you’d need to evaluate through thorough due diligence. You also need to consider illiquidity risk – does the structure of the fund you’re investing in align with your investment horizon and personal goals and financial situation?

Alternatives present significant potential both pre- and post-retirement, provided you select the right fund manager. Sanlam Investments Multi-Manager manages portfolios with alternatives as a sub-component to give the benefit of higher returns and lower correlation to the rest of the fund. We design and blend alternative asset classes to provide uncorrelated returns and portfolio diversification.

By Sanan Pillay, Portfolio Manager at Sanlam Investments Multi-Manager