An Introduction to Hedge Funds

Amid the intense market volatility seen over the last several years, investors are looking for ways to mitigate adverse portfolio fluctuations.

Hedge funds, with their historically low correlation to traditional asset classes, respond to this concern (although correlations have started to increase considerably over the past three years). These alternative investment vehicles may offer investors added diversification and a better chance to outperform the market over a longer timeframe. However, before committing capital, investors should be familiar with all facets of hedge fund investing.

The term “hedge fund” is a broad category that commonly refers to a private investment fund managing a large sum of money at its own discretion, sometimes employing strategies to “hedge” against certain market risks. Perhaps the most defining characteristic of hedge funds is that they are subject to fewer regulatory requirements than traditional investments. This allows the hedge fund managers, who are usually experienced investment professionals, to use creative strategies that fully utilize their expertise and often provide investors with attractive risk-adjusted returns. Another defining characteristic is that they tend to be limited to accredited investors. 

With few regulatory curbs on their investment strategies, hedge funds can use complex derivative instruments that reduce the correlations of their returns with the traditional asset classes. The main advantage of this is more diversification, as a hedge fund investment may act independently of broader market movements, which can provide a stabilizing effect on a portfolio during times of uncertainty. These added benefits have increased their popularity over the last few decades, with total assets increasing from $39 billion in 1990 to $2.13 trillion in the first quarter of 2012.

Hedge Fund Strategies

While particular strategies vary to a high degree, there are many strategies hedge funds use, which can be generally categorized as “directional” and “non-directional” strategies. Directional strategies try to take advantage of pricing inconsistencies in the market and often use leverage to maximize the returns earned on market swings. They tend to be more correlated with equity investments and the overall market. In contrast, non-directional strategies generally hedge against the risks of the market by using derivative instruments and short-selling techniques that may cause their performance to deviate widely from the market returns. These non-directional hedge funds tend to have lower correlations to the traditional asset classes, carry lower market risk (and lower expected returns) and are often used to reduce volatility in portfolios.

An alternative to investing in a single hedge fund strategy is to invest in a “hedge fund of funds.” Hedge funds of funds allocate investors’ money to a variety of hedge funds, covering multiple strategies and industries, which can provide an even greater level of diversification. This is a great investment for those who want to be exposed to a variety of hedge funds without committing a large sum of money to each of them. The biggest downside is their heightened fees, as the investor must pay fees to each underlying hedge fund as well as a fee for the fund of funds manager.

Hedge Fund Concerns

As with most alternative investments, hedge funds have some significant drawbacks that must be considered. One of the biggest concerns is the common industry practice of charging both regular management fees as well as incentive performance fees. This may result in large fees that erode the net performance of the investment. While performance fees can help align the manager’s and investor’s interests, they can also encourage excessive risk taking. Some hedge funds limit performance fees by setting a high water mark on performance fees, or setting a minimum hurdle rate that must be reached before they can begin to charge on positive returns.

Another common drawback is the lack of liquidity inherent with hedge fund investments. It is a standard in the asset class that investors may only redeem their money at a few specified intervals in the year, and they must notify the hedge fund in advance. Initial lock-up periods of one year are also commonplace. There is typically a portion of redemption proceeds that is held back until the annual audit of the fund is completed. Some hedge funds also have a gate provision which limits the amount of withdrawals investors can take from the fund. 

Furthermore, hedge funds tend to have a lack of transparency. Although lighter regulatory requirements give hedge funds the ability to execute creative strategies, they also limit the information that must be reported to investors. Obtaining detailed holdings and performance information on a timely basis can be difficult, which also complicates tax planning and compliance. Most hedge fund investors will be forced to file tax returns on extension while waiting on receipt of a K-1, a tax form that reports the investor’s share of the hedge fund activity for the year. When the K-1 is eventually received, it will frequently contain additional state income and foreign disclosure requirements, which can further complicate reporting and result in additional compliance fees.

While some hedge funds have generated very high returns in the past, there is also a risk of ending up on the other side of the equation. Some, but not all, hedge funds take on highly leveraged or highly concentrated positions. These and other unique investment and operational risks can put a more aggressive hedge fund at risk of catastrophic losses.

For investors who are concerned with high fees, compliance issues, lack of liquidity and transparency, and the loosely regulated nature of hedge funds, recent financial innovation has allowed for a different alternative. Hedge fund replication strategies are available in mutual fund and ETF structures, which are regulated under the Investment Company Act of 1940. These products have many of the same characteristics as traditional hedge funds, but eliminate some of the disadvantages by offering daily liquidity, transparency, reduced fees, efficient tax reporting and low investment minimums.

Conclusion

Hedge funds have become a significant part of the investment industry. Their ability to use unconventional strategies to provide diversification benefits makes them a very attractive addition to a balanced portfolio. Of course, they also come with a number of risks and consequences that investors must carefully consider before deciding hedge funds are right for their portfolio. Many institutional investors have hired in-house teams to provide their own due diligence on hedge fund managers. However, for the individual investor, it may be more feasible to work closely with your investment consultant with access to the resources necessary to effectively evaluate and monitor hedge fund management and performance.