What advisors should know about hedge funds in retirement planning

Hedge funds often get overlooked. However, for high-net-worth individuals with a well-diversified portfolio, they can serve a strategic role.

“Good candidates for hedge funds are those with long-term horizons, strong cash reserves, and little need to liquidate assets when there is market stress,” said Joe Braier, president and CEO of Lake Country Advisors.

Before introducing these assets, advisors should carefully assess a client’s net worth, liquidity requirements, and long-term objectives.

After all, the goal is to leverage alternative assets like hedge funds strategically, while ensuring clients have the liquidity they may need for demanding family obligations, business transition periods, or unexpected medical expenses.

Who are hedge funds for?

The reality is that hedge funds simply don’t make sense for most clients. Not only are they complex and illiquid, but they usually require accredited investor status, which already eliminates most retirees.

More often than not, clients are looking for two things from a retirement portfolio: protection and predictability. Chasing returns with alternative assets like hedge funds with money they can’t afford to lose is a gamble many don’t want to take.

That being said, if a client has significant assets well beyond their income needs, the hedge fund conversation may be worthwhile.

Paul Ferrara, senior wealth counsellor and chartered investment manager at Avenue, agrees that while net worth is important to consider before recommending hedge funds, it’s not everything. Whether a client relies on their portfolio to fund their lifestyle should be the real focus.

For example, someone with a $4 million portfolio who counts on the portfolio for 90% of his or her living expenses is not the same as a client with a $4 million portfolio to support baseline expenses after a pension and rental income have been netted.

“The number is the same. The risk profile is completely different,” Ferrara said.

For high-net-worth individuals who aren’t completely dependent on their portfolio, hedge funds may be valuable, as their illiquid nature may take years to pay off and outperform traditional investments.

According to J.P. Morgan, adding a 10% alternatives allocation to a traditional portfolio has been shown to enhance portfolio diversification and improve risk and return outcomes, ultimately supporting more attractive risk-adjusted returns over time.

If and when alternative assets like hedge funds are used, they should complement a broader retirement strategy.

Why terms matter as much as returns

When evaluating hedge fund opportunities with clients who may be a good fit, it’s imperative to understand their true terms.

“The fees charged, redemption restrictions, manager's ability to limit redemptions, and how each manager values the fund's assets are just as important as the intended returns,” Braier explained.

Chad Silver, founder and CEO of Silver Tax Group, echoes Braier’s thoughts.

Unfortunately, many advisors read the fact sheet, check the past performance and call it due diligence.

“They don't conduct a full fee analysis and or look into Unrelated Business Taxable Income (UBTI), which comes with some hedge fund structures in tax-deferred accounts and can lead to unwanted surprises,” Silver explained.

Just as stock market returns compound over time, the deleterious effects of high fees and additional taxes also compound over time. The late Jack Bogle, founder of Vanguard, referred to this phenomenon as “the tyranny of compounding costs."

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