The Potential Risks & Benefits of Hedge Funds Explained
- Introduction to hedge funds
- Three potential benefits of hedge funds, according to Mercer: diversification, asymmetry, and quality return
- Risks and limitations associated with investing in hedge funds
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The creation of the very first Hedge Fund dates back to 1949 when Alfred W. Jones coined the term ‘Hedged Fund’, meaning a fund that has offset directional market risk. Jones built the hedge fund structure by investing in the market while hedging for financial losses.
This structure, however, remained mostly unpopular until 1966 when Carol Loomis published, “The Jones Nobody Keeps Up With”, a piece that highlighted Jones and his unique approach to portfolio management.
Fast forward to today, there are over 10,000 hedge funds managing roughly $3.97 trillion in AUM, as of 3Q21, according to HFR.
To begin, hedge funds are not an asset class but rather a collection of investment strategies implemented across a wide range of markets and securities using a variety of techniques. The unconstrained nature of hedge funds — relative to their peers in the mutual fund space — and the variety of risk profiles means these strategies can serve a number of roles within a portfolio.
Most market participants cite alpha or return that is not attributable to market (or some other factor) risk, as the primary reason to invest in hedge funds.
Said differently, allocators believe that hedge funds are able to harvest unique sources of returns not readily available in traditional markets.
It is through the addition of these alternative return drivers that a portfolio begins to rely less on the direction of capital markets, resulting in a portfolio with a potentially lower correlation to public markets.
On the flip side, some critics would highlight that hedge funds often make use of increased leverage, and certain strategies expose investors to heightened left-tail risks. Other critics would point to the high investor minimums, increased fees, and lower liquidity.
Access to these private funds has also been a point of contention, as these funds have been traditionally reserved for institutions and sophisticated high-net-worth individuals. However, as the hedge fund industry evolves, there is a powerful movement to democratize this space.
Hedge Think. "The First Ever Hedge Fund."
Opalesque, October 21. "Global hedge fund capital steady as industry positions for inflation."
Fortune, April 1966. "The Jones Nobody Keeps Up With."
Mercer, May 2021. "Why Hedge Funds?"
Potential Benefits of Hedge Funds
An unconstrained toolkit affords a skilled manager the ability to not only harvest alternative premiums but also customize individual positions and portfolio risk and reward.
The unconstrained toolkit may include short selling, active hedging, leverage, concentration, activism, and litigation. While the alternative sources of return may include event risk, complexity and liquidity premiums, arbitrage, distressed securities, futures, macro-trends, and more.
There are three potential benefits of hedge funds, according to Mercer:
- Quality return
Traditional portfolios are dominated by two systemic risks: equity beta and interest rate risk. Conversely, hedge funds can access both financial and nonfinancial (commodity) markets and are properly equipped to take positions in an expanded set of investment opportunities. These opportunities seek to provide diversification benefits to an existing portfolio.
As shown below, over the past 20 years, hedge funds have delivered 1.1% - 3.8% of annualized alpha on average, net of fees after accounting for beta exposure to a combined 60/40 portfolio.
20-year annualized beta and alpha to 60/40 portfolio
Hedge funds seek lower volatility of portfolio returns by achieving a certain level of positive asymmetry. Asymmetric investing means the probability for upside is greater than the downside. Managers who successfully reduce drawdowns can allow for more consistent compounding, which is key to long-term portfolio growth.
Maximum drawdown over the last 20 years when global equities have fallen substantially
The below figure illustrates the average monthly upside and downside capture relative to global equities for certain hedge fund categories, demonstrating that hedge funds broadly exhibit favorable asymmetry.
Global equity capture – 20 years ending 2020
According to Mercer, Quality Return is defined as that which compensates for the risks taken and is efficient, as illustrated through measures such as the Sharpe ratio. By observing the Sharpe Ratio (a measure that indicates the annualized return minus the risk-free rate divided by the standard deviation of return) as a measure of quality, over the past 20 years hedge funds have provided an equal or higher-quality return relative to equities, as well as the 60/40 blend of equities and bonds. However, there are a wide variety of investment styles and approaches to select from and past performance is not a guarantee of future results.
Return quality comparison of different hedge fund strategies
The Risks and Limitations Associated with Investing in Hedge Funds
Like all investments, hedge funds come with their own set of associated risks. First and foremost, a hedge fund investor should be prepared to pay higher fees relative to a more traditional investing vehicle. Having said that, investors should focus on the net return delivered by the fund manager after all fees and not the absolute levels of fees themselves.
An investor should also be familiar with and be able to understand the memorandum documentation associated with the investment. This complex and sometimes lengthy document details the terms of the offering, and the risks of the investment, amongst other items.
Other issues include a lack of full underlying transparency/attribution & lagged reporting. This characteristic makes it more difficult for an investor to obtain and understand the underlying risk factors associated with the portfolio. This could lead an investor to be less familiar with how the allocation best fits within the context of a total portfolio.
Hedge funds also are less liquid due to potentially strict redemption terms. This attribute requires an investor to do extra diligence before deciding if it’s suitable to invest in this space.
And lastly, each hedge fund strategy or style comes with its own unique set of risks that need to be understood and reviewed carefully before investing. For example, convertible arbitrage strategies tend to be exposed to short selling, credit, and time-decay risks, while event-driven strategies tend to be market-sensitive and exhibit left-tail risk.
According to Mercer, there are three potential benefits of hedge funds: diversification, asymmetry, and quality return. The combination of asset classes, instruments, financing, risk factors, and portfolio levers coupled with effective implementation can deliver a risk/return profile that otherwise might be missing from a portfolio.
Financial advisors who are seeking hedge fund exposure must be disciplined, calculated, and able to understand the investment strategies and compare the unique risks and returns available to each of the hedge fund styles. It is important to understand that hedge funds are complex, speculative, and illiquid investment vehicles that are not suitable for all investors. Nevertheless, through a diversified collection of alternative risks and a disciplined risk-management approach, a well-constructed hedge fund exposure can help bring resiliency and diversification into a client’s portfolio.