How hedge funds work to diversify your portfolio

Investing Insights

Hedge funds originated in the 1940s when wealthy investors were looking for ways to generate performance in their portfolios that did not closely correlate with the performance of more traditional investments. Investors interested in what hedge funds could offer sought to potentially reduce risk and provide greater diversification to their portfolios.

Until recently, hedge fund clients were limited to large institutions that manage money for individuals or organizations, pension plans and clients with millions of dollars to invest. Today however, interest in hedge funds has broadened to include a wider group of individual investors.

If you’re considering adding hedge funds to your investment portfolio, it’s important to fully understand the structure, risks and potential benefits that are specific to hedge funds and the various investment strategies they represent.

How hedge funds work

Hedge funds fall under the category of “alternative investments,” as they’re managed in a way that’s different from other types of investment vehicles such as many traditional stock, bond or money market mutual funds.1

Hedge fund managers have significant flexibility in how they allocate investment dollars. They can choose to take “long” positions (with expectations that prices will rise) as well as “short” positions (anticipating a decline in value). The flexibility for managers to play “both sides” of a given market, asset category or security allows them to “hedge” their positions in an effort to limit the risk of an investment portfolio.

Along with strategies like purchasing or short-selling securities, hedge fund managers also make use of derivatives, such as options contracts, and can use leverage to expand their investments into particular securities. Leverage involves borrowing money to put additional dollars to work beyond the assets already accumulated in the fund. This is another feature that differentiates hedge funds from many traditional mutual funds.2

Potential benefits of hedge funds

Because hedge funds are managed differently, they offer some unique potential advantages to investors, such as:

  • Attractive risk-adjusted returns. A measure of the level of return received for a given level of risk. Many hedge funds emphasize their ability to generate competitive returns while effectively managing market volatility.
  • Diversification benefits in down markets. Over the past 20 years, hedge funds developed a solid track record of protecting investor capital during periods of market declines. The HFRI Fund of Funds Composite, a measure of hedge fund performance, shows that as a group, these hedge funds exhibited limited losses in periods when the broader stock market, as measured by the S&P 500, suffered significant declines.
Past performance does not guarantee future results. Returns shown represent results of market indices and are not from actual investments and are shown for ILLUSTRATIVE PURPOSES ONLY.
Past performance does not guarantee future results. Returns shown represent results of market indices and are not from actual investments and are shown for ILLUSTRATIVE PURPOSES ONLY.

Meanwhile, from 1990 to 2020, a period when traditional stock indices experienced substantial appreciation, hedge funds demonstrated an ability to keep pace with equity markets by managing portfolio risk that mitigates losses. This benefited investors when markets fell precipitously during the dot.com bubble, 2008 financial crisis and COVID-19 correction.

The graph below illustrates the performance of hedge funds as compared to the S&P 500 Index and Bloomberg Barclays US Aggregate Bond Index over the past 30 years, which captures each of these market corrections.

Past performance does not guarantee future results. Returns shown represent results of market indices and are not from actual investments and are shown for ILLUSTRATIVE PURPOSES ONLY.
Past performance does not guarantee future results. Returns shown represent results of market indices and are not from actual investments and are shown for ILLUSTRATIVE PURPOSES ONLY.
  • Variable market exposure. Since there are a wide range of hedge fund strategies, they can be positioned to either capitalize on a strong market (by exposing more than 100 percent of the portfolio to equities) or protecting the portfolio by holding less than full market exposure.
  • Ability to assume significant short positions. Short selling is a strategy regularly used in hedge funds as a way to capitalize on a potential decline in value for a specific security.
  • The possibility for upside regardless of market conditions. Hedge fund managers have tremendous flexibility to pursue attractive investment opportunities – during bear and bull markets alike – across security types, economic sectors and geographic regions, using a variety of sophisticated strategies.

Potential downsides of hedge funds

If you’re considering investing in hedge funds, it’s important to understand the possible shortcomings that might impact your experience. These include:

  • The speculative nature of hedge funds. Because hedge fund managers have a great deal of leeway in how they structure their portfolios, the investment could include more speculative types of investment strategies. Short selling, the use of leverage and derivatives can all add to the risk of an investment even though they’re applied with the intention of moderating risk.
  • High fee structure. Hedge funds typically charge both a management fee and performance fee. Management fees are typically between 1 percent and 2 percent annually, regardless of performance. In addition, most funds charge performance fees ranging from 15 percent to 20 percent of the profit generated by a fund in a given year. The better the fund performs, the greater the expense to the investor.
  • Lack of liquidity. Most hedge funds typically require a “lock-up” period of at least one year before investors can move money out of the fund.
  • Complex tax reporting. Money held in a taxable account can be subject to short-term or long-term capital gains or other types of investment taxation. Each year, hedge funds investors receive a form K-1 with tax reporting information. However, in many cases, those forms are not provided before the standard April 15 tax filing deadline, which may require investors to file a tax extension.
  • Choosing the right fund. As is the case with other types of funds, hedge funds vary in terms of key objectives and investment strategy. It’s important to identify funds with the investment characteristics that fulfill the needs of your portfolio.

Hedge funds fall under the category of “alternative investments,” as they’re managed in a way that’s different from other types of investment vehicles such as many traditional stock, bond or money market mutual funds.

Qualifications to invest in hedge funds

Potential investors must meet eligibility requirements to invest in a specific Fund. A Fund may require that the investor meet Accredited Investor, Qualified Client and/or Qualified Purchaser standards to invest. Definitions of standards are provided in the disclosure section.

Alternatively, an entity such as a trust with assets of more than $5 million or an entity where all investors are considered accredited investors can also qualify to invest in a hedge fund.

Selecting from different hedge fund strategies

Hedge funds pursue different investment strategies. Due diligence is a vital part of the selection process. It’s important to seek out hedge funds that demonstrate a solid performance and risk management track record but that also fit your specific investment objectives.

Here are six broad categories of hedge funds:

  • Equity hedge. This category is comprised of equity long/short funds and is the most used hedge fund strategy by investors. The fund’s premise is to buy undervalued stocks (long positions) and sell stocks considered to be overvalued (short positions). Such funds are often able to limit volatility compared to its competitive stock index by hedging its positions. These funds tend to maintain a large degree of exposure to broader stock market indices such as the S&P 500, but with less risk.
  • Long/short credit. These funds take long and short positions in the bond market. Much of the return comes in the form of coupon payment generated by the bonds and some from capital appreciation (in long positions) or depreciation (in short positions) depending on changes in a bond’s credit quality. These funds invest across various investment grades, maturities, types of collateralization and all levels of the capital structure used by a company to finance its operations and growth.
  • Event driven. Funds taking positions based on an event or catalyst that is expected to increase the value of the company’s stock or bond price. These can be events like the merger between two companies, a firm spinning out a subsidiary unit, or restructuring a company’s capital structure to improve its financial situation. The event, often referred to as a “special situation,” is key in determining the value of the stock or bond.
  • Relative value. A strategy seeking to exploit pricing differences of related financial instruments. They typically have less exposure to stock and bond markets compared to equity hedge and long/short credit strategies. Most of these funds focus on distressed debt and sovereign bonds, along with high yield and investment grade bonds.
  • Global macro. Funds having the broadest investment mandate of all hedge fund strategies, with the ability to invest in virtually all asset classes, markets and types of investments. Managers assess the global economic landscape and seek to profit from imbalances or dislocations due to macroeconomic and geopolitical events. Because of the significant leeway managers have in structuring the portfolio, these funds can generate attractive returns during periods of market uncertainty.
  • Managed futures. Strategies focused on trading futures and forward contracts on all types of commodities with the objective of generating an uncorrelated return relative to the stock and bond markets. Trading is usually directed by computer-driven algorithms rather than relying on the discretion of the fund manager. The models that result from these algorithms look to identify trends in the market for each specific commodity and take positions based on the expected direction of the commodity price. Managed futures are among the most liquid of the hedge funds available to investors.

Determining if investing in hedge funds is right for you

The potential benefits of investing in hedge funds are significant, but so are the potential downsides. Talk with your financial professional and take the time to understand the expected returns, risks and fees associated with investing in a hedge fund to determine if it’s a good fit for your portfolio and investment objectives.

Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Diversification and asset allocation do not guarantee returns or protect against losses.

Past performance is no guarantee of future results. All performance data, while obtained from sources deemed to be reliable, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for direct investment. The S&P 500 Index consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 1,400 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in U.S. dollar and have a minimum of $50 million under management or a 12-month track record of active performance. The HFRI Fund of Funds Composite Index consists of over 800 constituent hedge funds, including both domestic and offshore funds. Fund of Funds invest with multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. Alternative investments very often use speculative investment and trading strategies. There is no guarantee that the investment program will be successful. Alternative investments are designed only for investors who are able to tolerate the full loss of an investment. These products are not suitable for every investor even if the investor does meet the financial requirements. It is important to consult with your investment professional to determine how these investments might fit your asset allocation, risk profile and tax situation. Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund.

Accredited investor: For individuals, the requirement is generally met by a net worth that exceeds $1 million (excluding primary residence and any related indebtedness), income in excess of $200,000 (individually)/$300,00 (jointly with spouse) in the two most recent years with an expectation of the same in the current year, or individual has a Series 7, 65 and/or 82 securities license(s). (Relying on joint net worth or income does not mean securities must be jointly purchased.) For entities (including trusts, non-profit corporations exempt under s. 501(c)(3), LLCs, LLPs, corporations, etc.), the requirement is generally met with if the entity has assets in excess of $5 million (assuming the entity was not formed for the specific purpose of acquiring the securities offered), or when all of the entity owners are accredited investors. Please refer to Rule 501 under the Securities Act of 1933 for the complete definition. Qualified Client: The requirement is generally met if the investor has at least $1M under investment with the fund manager, the investor has a net worth of more than $2.1 million (excluding primary residence and any related indebtedness), or the investor is a Qualified Purchaser (see below). Please refer to Rule 205-3 under the Investment Advisers Act of 1940 for the complete definition. Qualified Purchaser: For individuals, the requirement is generally met when the investor owns (individually or jointly) $5 million or more in investments. [Relying on joint ownership of investments does not mean securities must be jointly purchased.] For entities (including trusts), the requirement is generally met if the entity owns $25 million or more in investments; the entity owns $5M or more in investments AND it is owned by two or more natural persons who are related as siblings/spouse; or all beneficial owners of the entity are each Qualified Purchasers. Please refer to Section 2(a)(51) of the Investment Company Act of 1940 for the complete definition.

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