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.
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.
- 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.
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