Hedge Funds: Higher Returns or Just High Fees?

Unlike common funds, hedge fund managers actively manage investment portfolios with a goal of absolute returns careless of the overall grocery store or exponent movements. They besides conduct their trade strategies with more exemption than a reciprocal fund, typically avoiding registration with the Securities and Exchange Commission ( SEC ) .

There are two basic reasons for investing in a hedge fund : to seek higher net returns ( net income of management and performance fees ) and/or to seek diversification. But how good are hedge funds at providing either ? Let ‘s take a front .

Key Takeaways

  • Hedge funds employ complex investing strategies that can include the use of leverage, derivatives, or alternative asset classes in order to boost return.
  • However, hedge funds also come with high fee structures and can be more opaque and risky than traditional investments.
  • Investors looking at hedge funds need to understand the cost-benefit calculation of a fund’s strategy and value proposition before putting money into it.

Potential for Higher Returns, Especially in a Bear market

Higher returns are barely guaranteed. Most hedge funds invest in the same securities available to reciprocal funds and individual investors. You can therefore only reasonably expect higher returns if you select a superior director or pick a timely scheme. many experts argue that selecting a talented coach is the only thing that in truth matters .

This helps to explain why hedge store strategies are not scalable, intend bigger is not better. With common funds, an investing process can be replicated and taught to newly managers, but many hedge funds are built around individual “ stars, ” and genius is difficult to clone. For this reason, some of the better funds are probable to be small .

A timely scheme is besides critical. The often-cited statistics from Credit Suisse Hedge Fund Index in regard to hedge store performance are revealing. From January 1994 to March 2021—through both bull and bear markets—the passive voice S & P 500 Index outperformed every major hedge fund scheme by over 2.5 % in annualized tax return .

If your commercialize mentality is bullish, you will need a specific reason to expect a hedge investment company to beat the index. conversely, if your mentality is bearish, hedge funds should be an attractive asset class compared to buy-and-hold or long-only reciprocal funds .

Looking at the period up to March 2021, we can see that the Credit Suisse Hedge Fund Index lags behind the S & P 500 with a net average annual performance of 7, .34 % versus 10.17 % for the S & P 500 ( since January 1994 ) .

diversification Benefits

many institutions invest in hedge funds for diversification benefits. If you have a portfolio of investments, adding uncorrelated ( and positive-returning ) assets will reduce total portfolio risk. Hedge funds—because they employ derivatives, short sales, or non-equity investments—tend to be uncorrelated with broad stock market indexes. But again, correlation varies by scheme. historic correlation data ( e.g. over the 1990s ) remains reasonably consistent, and here is a fair hierarchy :

Image 1
image by Julie Bang © Investopedia 2020

Fat Tails Are the Problem

Hedge fund investors are exposed to multiple risks, and each scheme has its own unique risks. For exemplar, long/short funds are exposed to the short squeeze .

The traditional measure of gamble is volatility or the annualized standard deviation of returns. amazingly, most academic studies demonstrate that hedge funds, on average, are less fickle than the market. For case, over the time period from January 1994 to March 2021, volatility ( annualized standard deviation ) of the S & P 500 was about 14.9 % while the volatility of the aggregated hedge funds was merely about 6.79 % .

The problem is that hedge fund returns do not follow the harmonious render paths implied by traditional volatility. rather, hedge store returns tend to be skewed. specifically, they tend to be negatively skewed, which means they bear the fear “ fat tails, ” which are by and large characterized by positive returns but a few cases of extreme losses .

For this cause, measures of downside risk can be more useful than volatility or Sharpe proportion. Downside gamble measures, such as value at risk ( VaR ), focus merely on the left side of the rejoinder distribution bend where losses occur. They answer questions such as, “ What are the odds that I lose 15 % of the principal in one year ? ”

Hedge Funds 2
A fatness tail means small odds of a boastfully personnel casualty.

trope by Julie Bang © Investopedia 2020

Funds of Hedge Funds

Because investing in a single hedge fund requires time-consuming due application and concentrates risk, funds of hedge funds have become popular. These are pool funds that allocate their capital among several hedge funds, normally in the neighborhood of 15 to 25 different hedge funds .

Unlike the underlying hedge funds, these vehicles are much registered with the SEC and promoted to individual investors. sometimes called a “ retail ” store of funds, the web worth and income tests may besides be lower than usual .

Hedge Funds 3
fund of funds structure .
image by Julie Bang © Investopedia 2020
The advantages of funds of hedge funds include automatic pistol diversification, monitoring efficiency, and choice expertness. Because these funds are invested in a minimum of around eight funds, the failure or underperformance of one hedge fund will not ruin the whole. As the funds of funds are supposed to monitor and conduct due application on their holdings, their investors should, in theory, be exposed only to reputable hedge funds .

last, these funds of hedge funds are often good at sourcing talented or undiscovered managers who may be “ under the radar ” of the broader investing community. In fact, the business model of the fund of funds hinges on identifying talented managers and pruning the portfolio of underachieve managers .

The biggest disadvantage is cost because these funds create a double-fee structure. typically, you pay a management fee ( and possibly tied a operation tip ) to the fund coach in addition to fees normally paid to the underlying hedge funds. Arrangements vary, but you might pay a 1 % management fee to both the investment company of funds and the underlying hedge funds .

In regards to performance fees, the underlying hedge funds may charge 20 % of their profits, and it is not unusual for the store of funds to charge an extra 10 %. Under this typical arrangement, you would pay 2 % per annum plus 30 % of the gains. This makes price a unplayful issue, tied though the 2 % management tip by itself is alone about 1.5 % higher than the modal small-capitalization reciprocal fund .

Another crucial and lowball hazard is the likely for over-diversification. A fund of hedge funds needs to coordinate its holdings or it will not add value : If it is not careful, it may unwittingly collect a group of hedge funds that duplicates its respective holdings or—even worse—it could become a representative sample of the entire market .

excessively many single hedge fund holdings ( with the aim of diversification ) are probably to erode the benefits of active agent management while incurring the double-fee structure in the interim. assorted studies have been conducted, but the “ angelic spot ” seems to be about eight to 15 hedge funds .

Questions to Ask

At this steer, you are no doubt aware that there are significant questions to ask before investing in a hedge fund or a fund of hedge funds. Look before you leap and make certain you do your research .

here is a number of questions to consider when seeking a hedge store investment :

  • Who are the founders and the principals? What are their backgrounds and credentials? How long before the founders/principals expect to retire?
  • How long has the fund been in business? What is the ownership structure? (E.g., is it a limited liability company? Who are the managing members? Are classes of shares issued?)
  • What is the fee structure and how are principals/employees compensated?
  • What is the basic investment strategy (must be more specific than proprietary)?
  • How often is a valuation performed and how often are reports produced for investors (or limited partners)?
  • What are the liquidity provisions? (E.g., what is the lock-out period?)
  • How does the fund measure and assess risk (e.g., VaR)? What is the track record in regard to risk?
  • Who are the references?

The Bottom Line

For most ordinary investors, hedge funds are out of range as they cater to high-net-worth individuals ( accredit investors ) who can muster the frequently six- or even seven-figure initial investment minimums. inactive, understanding a hedge fund ‘s likely for outsize returns must be weighed against its unique risks and higher fees .

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