How do hedge funds work to diversify your portfolio?

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. And until recently, hedge funds were only an option for pension plans, large institutions that manage money for individuals or organizations, and clients with millions of dollars to invest. Today, interest and participation 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 a hedge fund’s specific structure, risks and potential benefits. You’ll also want to consider the range of available investment strategies.

What is a hedge fund?

A hedge fund is an investment vehicle that pools money from many individuals and organizations and invests in a wide range of securities. Hedge funds put money to work in liquid and illiquid securities and, depending on the manager’s focus, employs different trading approaches across the various hedge fund strategies. “Investors can find value in hedge funds,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “It’s important that you carefully assess your options and try to find the most appropriate strategy to fit your portfolio.”

How do hedge funds work?

Hedge funds fall under the category of “alternative investments,” as they’re managed differently from more traditional types of investment vehicles such as stocks, bonds or mutual funds.¹

Hedge fund managers have significant flexibility in allocating 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 protect against downside moves while still seeking to generate gains during positive market periods.

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 and putting those dollars to work in addition to assets already accumulated from investors. This is another feature that differentiates hedge funds from many traditional mutual funds.²

What are potential benefits of hedge funds?

Because hedge funds are managed differently, they have the potential to provide unique features for investors, such as:

• Attractive risk-adjusted returns. Many hedge funds emphasize their ability to generate competitive returns while effectively managing market volatility.
• Diversification benefits in down markets. The HFRI Fund Weighted Composite, a measure of hedge fund performance, shows that as a group in recent years, hedge funds exhibited less severe declines in periods when the broader stock market, as measured by the S&P 500, sustained significant losses. It’s an indication of the potential diversification value hedge funds provide during periods of market volatility.

Meanwhile, from 1990 to 2023, a period when traditional stock indices experienced substantial appreciation, hedge funds generally tracked with equity markets by managing portfolio risk that mitigated losses. As the chart indicates, during periods of significant stock declines, such as during the early 2000s dot.com bubble, the 2008 financial crisis and the 2020 COVID-19 correction, hedge funds managed more stable performance.

The graph below illustrates the growth of $1,000 invested in hedge funds (as represented by the HFRI Fund Weighted Composite) as compared to the S&P 500 Index over the past 34 years, which captures each of these market corrections. Note that for most of the period shown, until 2020, hedge funds and stocks tracked very similarly in terms of performance.

• 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% of the portfolio to equities) or protecting the portfolio by holding less than full market exposure.
• Ability to assume significant short positions. Hedge funds regularly use short selling 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.

What are potential disadvantages of hedge funds?

If you’re considering investing in hedge funds, it’s important to understand some of the possible risks 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 and 2% annually, regardless of performance. In addition, most funds charge performance fees ranging from 15 to 20% of the profit generated by a fund in a given year. The better the fund performs, the greater the expense to the investor. “You want to be selective in choosing a hedge fund to include in your portfolio, and be certain you are being adequately compensated in terms of return potential for the costs you bear,” says Haworth.
• Lack of liquidity. Hedge funds are generally illiquid and therefore considered a long-term strategy. Hedge funds may apply various restrictions that affect your liquidity or investment potential. These include lockup periods (a period when you are not able to liquidate shares); withdrawal gates (allowing the fund manager the right to limit or halt fund redemptions during certain periods); and side pockets (which may restrict some new investors from participating in certain fund holdings). These tools may be used when there is a mismatch between the liquidity offered to clients and the liquidity of a portfolio’s underlying securities due to periods of market stress.
• 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. “It’s important that investors are aware of how hedge fund tax reporting can be more complicated than what they’ve become accustomed to with more traditional investments,” says Haworth.
• Choosing an appropriate 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.

How do you 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 below. 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 be qualified hedge fund investors.

If you’re eligible to invest in hedge funds, it’s vital to carefully select managers. “Be aware that certain hedge fund managers have a track record that demonstrates the meaningful value they offer,” says Haworth, “but others have not established extensive or competitive track records.” Hedge fund managers should undertake sourcing and due diligence processes to select funds that have a high probability of meeting the stated risk and performance targets. They should also work to identify funds that are well-suited for the goals and constraints of clients.

This is a comprehensive process requiring significant industry knowledge, resources and time. Constant monitoring of new hedge fund launches and closures is paramount to staying current due to the high levels of turnover experienced in this industry.

What are the investment strategies used by hedge funds?

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 strategy that investors most commonly use. Such a fund both buys undervalued stocks (long positions) and sells stocks considered to be overvalued (short positions). By utilizing hedging strategies, such funds are often able to limit volatility compared to their competitive stock index. These funds typically have heavy exposure to broader stock market indices such as the S&P 500, but with the potential to limit risk exposure by taking advantage of short selling strategies in down markets.
• Long/short credit. These funds take both long and short positions in the bond market. Much of the return comes in the form of coupon payments which bonds generate 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 collateralizations and all levels of the capital structure used by a company to finance its operations and growth.
• Event driven. Funds taking equity or fixed income positions based on an event or catalyst that is expected to increase a security’s value. Events can include company mergers, a firm spinning out a subsidiary unit, or restructuring of a company’s capital structure to improve its financial situation. The event, often referred to as a “special situation,” is key in determining a stock or bond’s value.
• 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 managers have significant leeway in structuring a 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 stock and bond markets. Trading is usually directed by computer-driven algorithms rather than relying on fund manager discretion. Models are based on algorithms seeking to identify trends that could impact specific commodities. Funds then take positions based on the expected direction of a commodity’s price. Managed futures are among the most liquid of the hedge fund offerings.

Is investing in hedge funds right for you?

The potential benefits of investing in hedge funds are significant, but so are the potential risks. “It’s important to work with a professional to consider whether specific hedge fund managers can add enough value to your portfolio for the risk you take on,” says Haworth.

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 an appropriate fit that can potentially enhance your portfolio and help you achieve your investment objectives.

Learn how we approach your long-term investing success.

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.

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.

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.