Hedge funds provide investors with an alternative to stocks and bonds. They usually promise high absolute returns, limited risk, and/or returns that are uncorrelated to traditional asset classes. They’re called “hedge” funds because most of the fund’s risk unrelated to the manager’s view is typically hedged, aiming to produce positive absolute returns under all market conditions. Hedge funds can be viewed as the most extreme version of active management: ideally, their return is entirely driven by manager skill rather than the overall market direction. But in real life, many hedge fund returns are highly correlated to stocks. For example, a recent paper estimated the correlation between the HFR Weighted Composite Index and the S&P 500 Index to 0.89 from 2010 to 2020.
Hedge funds collectively managed assets worth USD 6 trillion (USD 11 trillion when including capital plus borrowing) at the end of 2019. That’s a lot, but in a sense, it’s a modest amount compared to the USD 69 trillion value of mutual funds worldwide. According to Forbes magazine, the three hedge fund organizations managing the most assets are Bridgewater Associates (USD 124 billion), Renaissance Technologies (USD 106 billion) and AQR Capital Management (USD 95 billion).
Only half of the hedge fund universe is covered by commercial databases, while performance data about the other half is difficult to obtain because publishing returns through databases is voluntary. In contrast to conventional wisdom, the hedge funds that do not disclose tend to outperform those that do. A potential explanation for this outperformance may be that skilled hedge funds don’t need to advertise: sophisticated investors know who they are.
In contrast to mutual funds, hedge funds are lightly regulated and opaque. Their managers aren’t required to provide as much information about the fund’s operations and strategies. These managers often argue that disclosing too much of their activity would blunt their competitive edge.
Thanks to the commonly used limited partnership structure, hedge funds do not pay taxes on investment returns at the fund level. Returns are passed through to individual investors who pay the income tax.
Clever investors will pay attention to contractual terms: one-third of hedge funds restrict capital withdrawals with an initial lock-up period, sometimes lasting up to three years. Other restrictions include a fixed redemption schedule (monthly, quarterly, semi-annually or annually) and a notice period requirement (usually 30 to 60 days) to exercise the redemption right. Lock-up clauses are not all inconveniences, though, as they reduce funding risk. Some research has found that hedge funds with lower funding risk generate higher returns, driven by increased exposure to equity-mispricing anomalies.
Many consider hedge funds riskier than regular stock and bond funds. Their managers use complex short sales, derivative products and leveraged strategies to differentiate themselves from traditional asset managers. While a long position in an asset can result, at worst, in a 100% loss, short sales have an infinite loss potential. However, short sales can also “hedge” or reduce risk if matched with a long position on a highly correlated asset. The same can be said of derivative products and leverage: they can position the portfolio to amplify or mitigate potential gains and losses.
Because of their higher risk, complex strategies, opaqueness, and capital restrictions, hedge funds are primarily offered to institutional and individual accredited investors.
Hedge fund fee schemes are often expensive, combining base and performance fees. The compensation structure varies from one fund to another. It is generally asymmetric: if the fund manager adds value beyond a stated minimum requirement, they will receive extra income, but if they lose money, the manager will not compensate clients. However, the rationale for performance fees is to incentivize managers to perform at their best. Hedge fund compensation will be discussed in more detail in a follow-up post.
While their asymmetric compensation structure may induce hedge fund managers to take excessive risks, the latter sometimes co-invest in their funds to alleviate conflicts of interest. Nevertheless, observers claim that several hedge funds adopt negatively skewed investment strategies deemed analogous to picking up dimes in front of a steamroller, earning modest profits most of the time (and generating performance fees) until a rare event triggers steep losses.
A well-known case of negatively skewed investment strategy turning sour is the 2007 collapse of two fixed-income hedge funds run by investment bank Bear Stearns, a prelude to the demise of the bank itself the following year. Shrewd investors often point to excessively rosy risk-adjusted returns (or Sharpe Ratios) as a bad omen—and with good reason.
There are three broad types of hedge funds: single strategy, multi-strategy, and funds-of-funds. The distinction between a multi-strategy fund and a fund-of-funds is essential for two reasons. First, in contrast with multi-strategy funds, funds-of-funds charge multiple layers of fees. Second, multi-strategy funds charge performance fees based on the portfolio’s overall result. In comparison, funds-of-funds charge performance fees on their underlying individual funds, which can be much costlier. In a later post, we’ll discuss the collateral damage of performance fees for investors with a diversified portfolio of hedge funds. Remember that multi-strategy funds tend to be less expensive than funds-of-funds.
To summarize, hedge fund investors must understand the mechanics of each product and diligently analyze the contractual details of a fund before investing. Information on the type of fund, the compensation structure, management co-investment, and the willingness of management to regularly share information with investors must be evaluated. And, of course, investors must be selective in choosing hedge fund strategies compatible with their objectives. For example, an investor primarily looking to diversify away from stocks and bonds will avoid high-beta strategies.
There are dozens of hedge fund strategies. Our next post will provide insight into seven. While we will certainly not cover all possible strategies, we will provide examples of the three main types: relative value, event-driven, and directional strategies.
