Did you know the first hedge fund was established over seven decades ago?1 Yet, many investors still view them as something novel. In addition, bad press has followed the hedge fund community for years. Together these foster misconceptions of what hedge funds are and how they may fit into an asset allocation. Here's what you need to know to determine if they are right for you.
In the beginning…
In 1949, Alfred Winslow Jones had a hunch—he believed he could control risk and deliver better returns with a portfolio based solely on his security selection and not on the market's movement. To test his thesis, he bought stocks he thought would outperform the market and sold short those he thought would fall in value while maintaining (at the portfolio level) equal sums invested in those long and short positions. By doing this, he aimed to separate market risk—the movement of the whole market up or down—from individual security risk—the consequence of picking the right, or wrong, stock. The result? An equity market-neutral portfolio.
The long and the short of it
“Hedged” equity strategies—like Jones'—make up the highest percentage of today's active hedge funds, with more than $900 billion2 in assets among various substyles. Market-neutral funds aim to eliminate the market's direction from the equation. They seek to rely solely on the stock-picking skill of the managers to generate a return.
Other hedged equity strategies may have a net exposure (rather than being market-neutral). Long/short equity funds, for example, tend to have a net long exposure, meaning that a fund only partially offsets its long positions with its shorts. While the longs aim to provide upside growth by investing in companies expected to outperform, the shorts seek to generate returns from companies expected to underperform and/or hedge against a market decline. So, unlike the market-neutral portfolio, long/short equity funds' return comes from market exposure, known as beta—and stock-picking, or alpha. This allows for the potential to build wealth—from both the longs and shorts—with some downside protection.
Cushioning a blow
The potential for downside protection can be an important complement to equity-heavy portfolios. That's why these alternative strategies (which are often deployed through hedge funds) can—and often do—serve a crucial purpose for some investors, especially during market downturns.
Take the Global Financial Crisis. Equity hedge funds’ relative performance was nearly 30% better than the S&P 500 in 2008. (The S&P 500 fell 37.0% compared to 26.7% lost by equity hedge funds.)
The period following the Tech Bubble saw a similar result: The S&P 500 fell 11.9% and 22.1%, respectively, in 2001 and 2002, while equity hedge funds gained 0.4% and lost just 4.7% those same years.3 Even during the initial shock of COVID-19, equity hedge funds cushioned the blow. However, in strong directional markets—a prolonged bull market, for example—the offsets tend to be less effective.
A bad rap
Recently, though, hedge funds have gotten bad press, some for a good reason. For instance, many equity-focused hedge funds have underperformed broader market indices during the recent bull market.3 And a few highly leveraged strategies made headlines because–poof–one extreme event, and they blew up!
Some of the negative press is based on a misunderstanding or misconception of hedge funds and what role they can play in asset allocation. The fact is that a "hedge fund" is simply a catch-all term, and not all hedge funds are the same. Some are trying to beat the S&P 500. Others may be designed to play a precise role in a portfolio, such as mitigating downside risk or providing access to specific assets or strategies. As the intent of each fund differs, so do the goals, and so does the risk.
What's the risk?
Long/short hedge funds in particular face similar risks to traditional stock portfolios—such as mutual funds—because of their exposure to the equity markets, despite the protection offered by short positions. In other words, when the market falls, these funds may also decline. Sometimes that decline can be significantly more than the market because hedge funds can (and often do) use leverage.
Leverage comes in two forms: First is the use of borrowed money to make more investments. Second is the use of financial instruments (e.g., derivatives) that provide investment exposure beyond the amount invested. Regardless of the type employed, any use of leverage can amplify gains and losses, especially on the short side.
Hedge funds also have features of private market investments that may amplify their risk. Many require a "lock-up" period, in which investors cannot withdraw their investment for a specified period—generally at least 12 months. Outside of the lock-up period, typically investors can pull their money out only quarterly or monthly (compared to daily for mutual funds and ETFs). This creates liquidity risk, as the investor's money is tied up and not readily available. But, it serves an important function—to allow the investment team to act upon an idea and stay invested without constantly managing withdrawals.
A lock-up period mitigates the risk that many mutual funds and ETFs face—the detriment of having to force-sell investments to return capital to investors. This forced selling can reduce returns for the remaining investors and leave those investors with a less liquid portfolio. Unlike mutual funds, hedge funds are also able to impose other controls on flows, such as “gates” which partially limit the ability of investors to redeem from a fund. Gates can be imposed at either the fund or investor level. In extreme cases, hedge fund managers can completely and temporarily prohibit redemptions. So while illiquidity may reduce investors' control over their assets, it can add value to the hedge fund's long-term returns.
Lack of transparency and regulatory oversight are other risks. Over the years, hedge funds have been scrutinized for their secrecy. Many feel their competitive advantage lies in the complex strategies they employ. Keeping a tight lid on how they implement their strategy, they believe, reduces the risk that a competitor may reverse-engineer their strategy.
Although regulators have been looking closer at the industry since the 2008 financial crisis, many hedge funds are not subject to some of the laws and Securities & Exchange Commission (SEC) rules and regulations designed to protect investors in traditional mutual funds. For example, unlike mutual funds, hedge funds generally do not have restrictions on their use of leverage, including derivatives.
Who can invest?
To protect individuals who may not be able to weather the potential risks, hedge funds are only open to certain investors—accredited investors (AI) and, depending on the hedge fund, qualified purchasers (QP). Restricting to these investors also allows hedge funds to charge performance-based fees in addition to the standard flat fee. A qualified purchaser is the more stringent of the two, but many funds require both.
Of course, this is only a high-level summary of these terms and the application of these definitions to investors is often highly nuanced. Investing in hedge funds can be complex, so we encourage you to seek legal advice from qualified professionals.
The right fit
Investors have short memories when they're making money. But the COVID-19 pandemic, Global Financial Crisis, and Tech Bubble serve as reminders that markets can rapidly hit the skids and drop significantly. Choosing an asset allocation that is right for your risk tolerance is essential. Hedge funds—for the appropriate investors—can be a part of that equation. Because creating wealth while protecting from extreme losses is an idea most investors can get behind.