2020 was a devastating year for the global economy. The COVID pandemic wreaked havoc on businesses and investments alike. Hedge funds, however, were resilient during this time, with over 77% delivering a positive annual return, according to Citco’s 2020 Hedge Fund Report. Every investment category was in the green overall, but this isn’t surprising considering the whole point of a hedge fund is to beat the market regardless of its condition.
Let’s explore what hedge funds are and determine if they have a place in your portfolio. But first, let’s qualify this by saying there are perhaps 15,000 or more hedge funds in the United States. Many of them are relatively small with diverse strategies, so generalizing has pitfalls.
What Is A Hedge Fund?
Like mutual funds and ETFs, hedge funds use pooled funds to buy various investments and securities. Their goal is to make investment strategies to generate high returns. Where they differ is that hedge funds often employ aggressive investment strategies like short-selling and leverage investing.
It’s the goal for the hedge fund to earn alpha, or excess return, for investors. Since these types of returns are achieved beyond normal returns, the investment risk is high due to the strategies employed to obtain these results.
Who Can Invest In Hedge Funds?
The Securities and Exchange Commission (SEC) holds strict regulations on who can invest in hedge funds due to the inherent risk of investing strategies used. Institutional investors make up most of the hedge fund market, including banks, insurance companies, pension funds, and mutual funds. These are the whales you hear about on Wall Street that can move markets at will.
Individuals can invest in hedge funds, but they need to be accredited investors with a net worth of at least $1.1 million. The net worth excludes their primary resident’s value and individual annual incomes exceeding $200,000 for singles and $300,000 for married couples. According to the United States Census Bureau, less than 5% of households earned more than $300,000 needed to reach accredited investor status in 2019.
Why Invest In Hedge Funds?
As all investors know, diversification is key to reducing overall volatility, which leads to a healthy portfolio. High net worth accredited investors or institutional investors will look for investments to offset the risk of negative price movements. They often look for investment hedges that are uncorrelated with the rest of their investments, particularly the stock market.
Hedge funds provide another layer of diversification to institutional investors that aren’t accessible to a typical retail investor.
Various Investment Strategies
To generate alpha, hedge funds will use various investment strategies. It’s common to see investment strategies such as leverage, long/short, and derivatives employed. Here are a few of the common strategies that hedge funds are known for.
- Long/Short Equity
Taking long and short positions in equity and equity derivative securities is commonly used with hedge funds. The fund manager will make a pair trade to invest in two securities within the same industry. For example, a hedge fund manager may make a long investment in the company they perceive to be the strongest or best managed and short the worst company in the industry. That way, if the sector falls out of favor, they have a hedge against loss of capital.
- Relative-Value Arbitrage
Hedge funds will seek opportunities to profit from price differentials between related securities such as stocks and bonds. They will buy and sell different securities at the same time to establish a relative value between them. These pairs typically have a high correlation with each other, so when one increases in price, the other increases as well.
- Global Macro Strategy
When using a global macro strategy, the hedge fund will base the majority of its holdings on different countries’ overall political and economic views. Long and short positions may be held in various currencies, commodities, equities, or futures markets. Their predictions are based on various factors, which include politics, interest rates, foreign policies, currency exchange rates, and international trade, to name a few.
Pros Of Hedge Fund Investing
With any investment, you’ll need to weigh your options before making a decision. Let’s take a look at why you should invest in hedge funds.
Outsized Gains
The entire purpose of a hedge fund is to generate high-return gains regardless of what the market looks like. One popular strategy for hedge funds is the “global macro” approach. Since this strategy bases its holdings primarily on the future global political and economic picture, it serves as a hedge against volatility in current market dynamics.
Flexibility
Hedge funds have more flexibility than other investments because they have access to non-traditional assets and strategies. Depending on the hedge fund, you’ll see strategies such as short selling, leverage, and derivatives being utilized to invest in basically anything. Mutual funds, for example, are stuck with going long on stocks and bonds, while hedge funds can make short plays in real estate, land, currencies, and derivatives.
Reduce Risk Exposure
When diversifying your portfolio with hedge fund investments, it’s often the case that risk exposure to general market movements can be reduced drastically by focusing on specific risks. These include risks associated with the market, liquidity, credit, interest rate, country, and currency. The fund could choose investments that can lower downside volatility and correlation level than the general risk assets present in the existing portfolio.
Hedge Against Market Downturns
Most portfolios consist of investments that depend on the health of their respective markets. If you have any stocks or ETFs, it’s in your best interest if the markets you invested in are on an upward trend. If the majority of your portfolio consists of stocks and ETFs, you’re exposed to potential market downturns in your invested industries.
Many hedge fund managers claim profit in any market, up, down, or flat. A prudent investor should examine past returns in all kinds of market conditions.
Cons Of Hedge Fund Investing
While the pros may sound appealing, it’s prudent to understand the cons to determine if hedge fund investing is right for you.
Huge Fees
Two and twenty. These are the standard percentages that hedge funds charge for assets under management (AUM) and standard performance. Although lucrative for the hedge fund manager, these are large sums of money you’ll need to pay. To put this into perspective, if a hedge fund manager has $1 billion in AUM, $20 million in management fees will be paid annually. Additionally, when the fund performs better than the hurdle rate (not all funds have this), which is a minimum required rate of return, expect to see a 20% performance fee charged.
Though the fee may seem high, it serves as a great incentive and often attracts the best and brightest of their generation with its outsized compensation potential. Any sports fan will understand that the best players command the highest salaries and that a winning team consists of several highly paid athletes. A sports team won’t win if they are full of low salaried players. Hedge funds work in the same way. Your hedge fund managers are the players, and each hedge fund employs the best and the brightest.
Most funds use a high-water mark to ensure that the fund manager is not paid huge sums if performance is poor. If the manager had a particularly bad stretch, there would be an obligation to get the fund to a level above this high-water mark before receiving a performance-based bonus.
Risk Exposure In Leveraging
Leveraged investing is one of the main strategies that hedge funds employ. This strategy can obtain high returns, but losses can magnify when investments fail to grow above the borrowed cost. Investing with borrowed money usually comes with higher risk exposure. When George Soros was convinced that the Bank of England would have to devalue the pound, he leveraged up everything he could and amassed an enormous, $20 billion short position against the pound. The rest is history. He’s famous for saying, “when you know you’re right, there is no bet too big.”
If you’re pondering this situation, whether to invest all at one, please feel free to reach out to me at Chase Thomas chtomas@alphawealthfunds.com and I’ll be happy to discuss it and possibly show you better strategies to accomplish your goals.