Why Should You Actively Invest in Hedge Funds?

Hedge funds have gotten off to a better start in 2019 as compared to last year. After three months of consecutive growth, the 2019 First Quarter year-to-date average gains are the industry’s best since the beginning of 2012. [1] This news may lead you to want to know more about hedge funds and their role in an investment portfolio. We’ve answered some common questions about hedge funds below.

Are all hedge funds created equal?

No. While technical definitions vary, hedge funds can be broadly defined as actively managed pools of capital following unconventional investment strategies. These are typically unregistered investment vehicles intended for sophisticated institutional investors and high-net-worth individuals. In the truest sense, “hedge funds” is not an asset class, but rather a legal structure facilitating an amalgam of strategies invested across various asset classes.

The term “hedge fund” serves as a catch-all phrase for private investment partnerships that can invoke short-selling (betting the price of a security will fall), regardless of whether true hedging techniques are actually employed.

What is the role of hedge funds within a broader investment portfolio?

Hedge funds have many roles within an investment portfolio. We believe the overall goal is to improve risk-adjusted performance by primarily protecting capital and generating uncorrelated returns during periods of stress. Historically, hedge fund returns have been in line with long-term equity returns, but with bond-like volatility.

Although investors have a wide range of risk/return parameters, hedge funds are predominantly viewed as absolute return vehicles with the expectation that the asset class will perform well during more volatile periods, especially during market turmoil.

Recent headlines suggest only owning passive index funds. Why should one invest in actively managed hedge funds?

With the proliferation of extremely low-cost index funds across a variety of asset classes, the ability to gain access to basic market exposures (beta) is simple and cheap. However, we continue to believe that effectively incorporating these strategies in a diversified portfolio requires both skill and knowledge, especially when building a customized portfolio for a client’s unique objectives and circumstances. Hedge funds, as opposed to index funds, are alpha-generating vehicles and should have very little beta.

Alpha is the return on an investment that is not a result of a general move in the greater market. An optimal asset allocation strategy typically includes both beta and alpha. Identifying unique, alpha-generating funds can be challenging, but doing so can also improve the risk-adjusted performance of a portfolio.

Given hedge funds charge higher fees than traditional asset classes like stocks and bonds, should the returns be higher? What is an appropriate performance expectation?

While hedge funds charge higher fees than traditional asset classes, we believe that hedge funds should provide returns that are uncorrelated to moves in the market and can ultimately reduce the risk in an investor’s portfolio.

If a hedge fund does in fact deliver alpha, it can be incredibly accretive to a portfolio that already has equity market exposure through its long-only and private equity allocations. Therefore, truly exceptional hedge funds can demand a pricing premium. The average hedge fund, however, does not add value to an investor’s portfolio and should not demand this premium.

Performance expectations for hedge funds range depending on the strategy, but a realistic return expectation is somewhere between the long-term return on U.S. bonds and stocks.

While many hedge fund returns have lagged visible benchmarks like the S&P 500, it’s not surprising that investors have begun to question the value of their hedge fund allocation. We’d emphasize that recent S&P 500 returns were extremely high relative to history and are unlikely to persist. It is reasonable that long-term return expectations for hedge funds and broader equity markets converge to more normal levels in the future.

What is the best benchmark for my hedge fund portfolio in order to evaluate performance?

In theory, a good benchmark should be investable and approximate the opportunity set, neither of which are true across all hedge funds. Hedge fund benchmarking remains a futile exercise. While benchmark information is widely available, there are complications.

Data is self-reported and a manager must actively choose to submit their results to the database provider for inclusion. While not always true, it’s intuitive that a manager might be more likely to submit performance results when they are good.

If this is the case, the benchmark would theoretically be biased higher and further reduce the motivation for managers to embrace benchmarks in the industry as managers aim to exceed their peers. Managers who aren’t currently fundraising might not feel obligated to submit their results to databases, further adding to the discrepancy between what is investable versus what is available.

There are also distinctions across managers within the same strategy. The Long/Short equity manager, for example, may only invest in a single sector and comparing that manager against a generalist peer group that invests across multiple sectors doesn’t make sense.

Uncovering a true peer group through the due diligence process can help identify a more focused list of managers for better benchmarking of a particular strategy.

If you have questions about the role hedge funds should play in your portfolio, contact an Fi3 advisor today.

[1] Hedge Funds Returns YTD Best Since 2012, Says eVestment, April 11, 2019