Hedge Funds: Do They Produce Better Returns or Just Charge Exorbitant Fees?
Hedge fund managers, unlike mutual fund managers, actively manage investment portfolios with the purpose of achieving absolute returns regardless of market or index movements. They also have more flexibility in their trading techniques than a mutual fund, often evading registration with the Securities and Exchange Commission (SEC).
There are two main reasons to invest in a hedge fund: to increase net returns (after management and performance fees) and/or to diversify your portfolio. But how effective are hedge funds in providing either of these services? Let’s have a look at what we’ve got.
Important Points to Remember
- In order to increase returns, hedge funds use complex investing strategies such as leverage, derivatives, and alternative asset classes.
- Hedge funds, on the other hand, have high fees and can be more opaque and hazardous than typical investments.
- Before investing in a hedge fund, investors should understand the cost-benefit analysis of the firm’s strategy and value proposition.
Higher Potential Returns, Especially in a Bear Market
Higher profits aren’t always guaranteed. The majority of hedge funds invest in the same types of securities that mutual funds and individual investors do. As a result, bigger returns can only be expected if you choose a superior management or a timely strategy. Many experts feel that hiring a good manager is the most important factor.
This explains why hedge fund strategies aren’t scalable, implying that more isn’t always better. An investment process can be copied and taught to new managers in mutual funds, but many hedge funds are created around individual “stars,” and genius is tough to duplicate. As a result, some of the better funds will most likely be modest.
A well-timed plan is also essential. The often-cited numbers from Credit Suisse Hedge Fund Index in reference to hedge fund performance are instructive. The passive S&P 500 Index beat every major hedge fund strategy by over 2.5 percent in annualized return from January 1994 to March 2021, during both bull and bear markets. 1
If your market forecast is bullish, you’ll need a compelling reason to believe that a hedge fund can outperform the market index. In contrast to buy-and-hold or long-only mutual funds, hedge funds should be an appealing asset class if your view is gloomy.
Looking ahead to March 2021, the Credit Suisse Hedge Fund Index behind the S&P 500 with a net average annual return of 7.34 percent versus 10.17 percent for the S&P 500. (since January 1994).
Benefits of Diversification
Hedge funds are popular among financial organizations because they provide diversity. If you have an investment portfolio, adding uncorrelated (and positive-returning) assets will lower your overall risk. Hedge funds are uncorrelated with broad stock market indices because they use derivatives, short sells, or non-equity assets. However, correlation varies depending on the technique. Historical correlation data (for example, from the 1990s) is fairly consistent, and the following is a realistic hierarchy:
The Issue Is Fat Tails
Hedge fund investors are exposed to a variety of risks, with each strategy posing its own set of challenges. The short squeeze, for example, affects long/short funds.
Volatility, or the annualized standard deviation of returns, is a conventional risk indicator. Surprisingly, most academic research show that hedge funds are less volatile than the market on average. For example, the volatility (annualized standard deviation) of the S&P 500 was roughly 14.9 percent from January 1994 to March 2021, but the volatility of the aggregated hedge funds was only about 6.79 percent. 1
The issue is that hedge fund returns do not follow traditional volatility’s symmetrical return patterns. Hedge fund results, on the other hand, are distorted. They are specifically negatively skewed, which means they have the feared “fat tails,” which are characterized by largely positive returns with a few examples of significant losses.
As a result, measurements of downside risk, rather than volatility or the Sharpe ratio, can be more relevant. Value at risk (VaR) and other downside risk measurements concentrate solely on the left side of the return distribution curve, where losses occur. They respond to inquiries like, “What are the chances that I will lose 15% of my investment in a year?”
A fat tail indicates a low probability of a major loss. investingclue 2020 image by Julie Bang
Hedge Funds’ Funds
Funds of hedge funds have become popular because investing in a single hedge fund takes time-consuming due diligence and concentrates risk. These are pooled funds that distribute their capital among a number of hedge funds, usually between 15 and 25, depending on the size of the fund.
These vehicles, unlike the underlying hedge funds, are frequently registered with the Securities and Exchange Commission (SEC) and advertised to individual investors. The net worth and income requirements may also be lower than normal in a “retail” fund of funds.
Automatic diversification, monitoring efficiency, and selection skill are some of the benefits of hedge funds. Because these funds are spread across at least eight hedge funds, the failure or underperformance of one will not derail the entire portfolio. Because funds of funds are required to monitor and perform due diligence on their assets, their investors should only be exposed to reputable hedge funds in principle.
Finally, these funds of hedge funds are typically adept at identifying brilliant or undiscovered managers who may be “off the radar” of the greater investment world. In fact, the fund of funds’ business model is based on recognizing outstanding managers and trimming the portfolio of underperformers.
The most significant downside is the expense, as these funds impose a double-fee structure. In addition to the fees ordinarily paid to the underlying hedge funds, you usually pay a management fee (and maybe a performance fee) to the fund manager. You might pay a 1% management fee to both the fund of funds and the underlying hedge funds, depending on the arrangement.
In terms of performance fees, the underlying hedge funds may charge up to 20% of their gains, with the fund of funds often charging an additional 10%. You would pay 2% per year plus 30% of the gains under this usual agreement. Even though the 2% management charge is just around 1.5 percent higher than the average small-cap mutual fund, this makes cost a real concern.
The risk of over-diversification is another key and underappreciated issue. A hedge fund of hedge funds must coordinate their assets in order to add value: If it isn’t careful, it could end up collecting a group of hedge funds that mirrors its varied holdings, or worse, it could become a representative sample of the entire market.
Too many single hedge fund holdings (in the name of diversity) are likely to diminish the benefits of active management while simultaneously incurring the double-fee structure. Various research have been undertaken, but it appears that the “sweet spot” is between eight and fifteen hedge funds.
Questions to Ponder
You’re probably aware that there are some crucial questions to consider before investing in a hedge fund or a fund of hedge funds at this point. Make sure you look before you leap and that you have done your homework.
When looking for a hedge fund to invest in, consider the following questions:
- Who are the company’s founders and principals? What are their qualifications and backgrounds? When do you think the founders/principals will retire?
- When did the fund start and how long has it been in operation? What is the ownership structure of the company? (Is it, for example, a limited liability company? Who are the members of the management team? Are there several types of shares?)
- How are principals/employees compensated and what is the fee structure?
- What is the primary investment strategy (it should be more precise than proprietary)?
- How often do you perform valuations and produce reports for investors (or limited partners)?
- What are the provisions for liquidity? (For example, how long is the lockout?)
- How does the fund measure and assess risk (e.g., VaR)? What is the company’s track record when it comes to risk?
- What are the sources of information?
Hedge funds are out of reach for most ordinary investors since they cater to high-net-worth individuals (accredited investors) who can afford the six- or even seven-figure initial investment minimums. Nonetheless, the outsized return potential of a hedge fund must be evaluated against its unique dangers and higher expenses.