A Wall Street Journal article entitled, "Hedge Funds Drive to Another Record," (WSJ, 04/22/14, page C-1) noted that despite their recent lackluster returns, hedge funds are a popular investment tool and have grown dramatically in assets under management (AUM). In 2013 for example, hedge fund returns averaged 9% after fees, while the S&P 500 was up 32%, 3.5 times the average hedge fund’s return. In Q-1 2014, the total average return for hedge funds was 1.1%, compared to 1.8% for the S&P 500. Ironically, Q-1 2014 was also the seventh consecutive quarter in which hedge funds hit a new record -- $2.7 trillion in AUM -- by adding $26 billion to AUM in that quarter. Why do hedge funds continue to be such a popular investment despite their disappointing recent returns?
As a result of the Financial Crisis, most investors have learned not follow the herd. But is the continued popularity of hedge funds driven by a herd mentality? Instead of focusing on AUM, investors should ask, “Are hedge funds a useful tool for my portfolio?” I share with you here six considerations about investing in hedge funds. I have also included three critical success factors for managing your hedge funds.
First, you may want a quick refresher on what a hedge fund is. A hedge fund is an investment vehicle with:
- Constrained access: only sophisticated investors need apply,
- Limited withdrawal capacity: often times, you are only able to withdraw assets quarterly, and lock-ups may be as long as three years,
- Enormous investment flexibility: in that hedge funds may use:
- leverage (borrowing money to make your money work harder),
- shorts (borrowing an asset the hedge fund does not own and selling it, with the hope of buying it back at a later date, at a lower price, and returning it to the firm from which it was borrowed),
- exotic instruments (such as derivatives), and
- other tools not common to most investors’ traditional portfolios.
- Tax reporting consequences: hedge funds typically issue a complicated K-1 vs. a 1099, and they often produce K-1’s after April 15th, meaning that investors must file their taxes on extension.
- Higher than common fees:
- a management fee of 1.5% to 2%,
- a participation in your profits, often 20%, and
- operating expenses (e.g., audit, legal and administrative fees).
Six Considerations to Address with Your Investment Advisers When Investing in Hedge Funds
- How have your hedge funds performed relative to your other investments? Specifically, how have your long-term hedge fund returns been vis-a-vis your other asset classes and capital market benchmarks? Do you have an absolute standard for the return you want to generate? How have your hedge funds performed vs. that goal? The answers to these questions are more important than whether the hedge fund industry’s AUM is up or down.
- Are you fully satisfied with your hedge fund selection process? Manager selection is always important, but the hedge fund environment is particularly complex with limited public information. Additionally, since hedge funds have liquidity constraints, you are not free to terminate an unsatisfactory investment on a moment’s notice. The best information regarding detailed fund-by-fund returns and thorough due diligence about hedge funds is highly proprietary. Most wise investors retain an expert consultant to assist them with manager selection.
- Has your hedge fund program offered protection for your portfolio in periods of crisis? The years 1987, 2001 and 2008 were particularly difficult for investors. Be sure to evaluate the returns of each of your current (or potential) hedge funds to see how well each of them behaved during periods of financial crisis or severe stress.
- Are your hedge funds equity alternatives or fixed income alternatives? If a fund is to be used as fixed income alternative then it should not be compared to the returns of the S&P 500. You need to have a candid dialogue with your advisers and/or each hedge fund manager to develop a fair and appropriate set of expectations about each fund’s investment return and volatility.
- What role do you want hedge funds to play in terms of managing your portfolio’s volatility? Hedge funds can play a favorable role in reducing volatility. You may be well-advised to accept a reduced return compared to the S&P 500, or other capital markets return, if the hedge funds you invest in can reduce the overall volatility of your portfolio and achieve a predictable return.
- How much organizational risk can you accept? In building a hedge fund portfolio, you can put hedge funds roughly into three categories:
- Mega Managers: These are large, multi-billion dollar funds with the capacity to accept significant additional AUM. Their names may appear in the business press with some regularity. They may even be publicly traded companies, or belong to large public financial institutions. These mega funds typically have the least organizational risk. On the other hand, they may not be the most interesting and rewarding funds over the next 10 years – they have already made it big.
- Institutional Main Stream: These funds are somewhat smaller, and may be highly selective in taking additional investor assets – many are open only with a suitable introduction. They may not be willing to engage in fee-sharing with financial institutions that sponsor hedge fund platforms. These funds tend to avoid the press and are hard to find without expert assistance. While they may have more organizational risk than the mega managers, they are well- established businesses (nonetheless professional due diligence is essential).
- Emerging Managers: These funds have $50 million - $1.5 billion in AUM and may have the greatest organization risk. Investors typically engage specialized expertise in the emerging funds arena to help them ‘get it right’ (i.e., stay out of trouble). All that said, there can be very rewarding investment opportunities with emerging funds.
Three Critical Success Factors for Investing in Hedge Funds
- Determine the strategic role for your hedge funds: Wise investors do not embrace hedge funds to follow the herd. Nor do they employ hedge funds to maximize short-term returns. Prudent investors hire hedge fund managers to accomplish an important role in their portfolio in terms of risk/volatility management. Their mission is to achieve favorable long-term returns that are more muted than long-only equities, but attractive nonetheless.
- Evaluate structural considerations: Informed investors understand the liquidity limitations of their hedge fund portfolios, as well as the fee burdens that hedge funds bear. Furthermore, thoughtful taxable investors explore the after-tax returns from their hedge fund portfolios.
- Build an effective management team: Prior to embarking upon hedge fund investments, sensible investors are careful to assemble the right professionals and a deeply experienced investment committee to help them to construct and manage a highly successful program.
If you have a comment on this article, please use the comment box below. Leaving comments allows readers to expand upon the topics covered in my articles. So please help us all by commenting. If you would care to discuss investing in hedge funds with me personally, please drop me an email or give me a ring at 617.945.5157.