With the recent approval in July by the SEC that will allow hedge funds to advertise and market themselves, I thought it would be a good time to write about what hedge funds are designed for and some risks you should know about. This is not meant to imply all hedge funds are risky or bad investments, because there are some fine hedge funds out there. However, you should be aware of what these investments are because you are probably about to be exposed to their advertising.
1. Who are hedge funds designed for
For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the hedge fund must be accredited. That is, they must meet certain annual income requirements and have a net worth of more than $1 million excluding a primary residence. The idea is that investors who meet these requirements will have a significant amount of investment knowledge. Hedge funds can be thought of as mutual funds for the institutional and ultra-high-net-worth investors.
Hedge funds are generally illiquid investments as they often require the investor to keep their money in the fund for at least one year. They often invest speculatively to maximize capital appreciation. Most hedge fund investment strategies aim to achieve a positive return on investment regardless of whether the market is rising or falling. Because hedge funds aren’t sold to the to the general public , the funds have historically been exempt from some of the regulation that governs other investment managers with regard to how the fund may be structured and what strategies and techniques are employed.
2. Most Hedge Funds are a “black box”
After the financial crisis in 2008, hedge funds were under pressure to become more transparent. Many complied, but most are still a black box, meaning investors can’t actually find out what the fund is investing in and what risk is being taken with their money. Unlike most mutual funds or investment advisors, hedge funds can use large amounts of leverage and other risky techniques to increase returns. They are under no obligation to disclose how they achieved their historical results. An investor essentially wires money to the fund and waits for statements to show up to see if their money has appreciated or not. They will never know what they are invested in. This can be risky and is why hedge funds are not for most investors.
The name “hedge fund” can be misleading as well. The first hedge funds were designed to protect assets during bear markets by shorting stocks, which mutual funds were not permitted to do. Today, hedge funds use dozens of different strategies, so it is not accurate to say that hedge funds necessarily hedge risk. The fact of the matter is because hedge fund managers often make speculative investments, these funds can have more risk than the overall market.
3. Hedge Fund Costs and Returns
Hedge funds are expensive investments. The most common cost structure is 1% of assets under management per year plus 20% of profits. Some cost more, but rarely will you find one that costs less. Because of this, hedge funds are incentivized to do whatever it takes to outperform their benchmark.
The annual percentage fees generally go to operating the fund while the outperformance bonus is where the big money is for the manager. Since hedge funds have no fiduciary or suitability standards to meet for their investors, hypothetically they could take on huge amounts of risk if it looks like they might trail the stated benchmark, thus putting investor capital in jeopardy.
It is difficult to justify the risk associated with most hedge funds based on historical returns. Most don’t outperform their stated benchmark. In fact, in aggregate they generally lag the broad market. In fact, hedge funds have cumulatively underperformed a basic vanilla 60/40 stock-bond index going back 10 years.
According to a report from Goldman Sachs released in May, hedge fund performance has lagged the S&P 500 by approximately 10%. As of the end of June, hedge funds had gained just 1.4% in 2013 and have fallen behind the MSCI All Country World Index for five of the past seven years, according to data compiled by Bloomberg.
There are some hedge funds that can and do beat the market consistently but, for the most part, don’t want your money. They have more than enough investors already. So in order to attain market-beating returns, you must locate the next great fund. Many of the funds that you will see advertised in the near future will probably be the ones you don’t want to be invested in.
Putting it All Together
I want to reiterate that not all hedge funds are bad but they just aren’t suitable investments for every investor. They are designed for people who can afford to take on the risk in exchange for outsized returns. If you’ve worked your whole life and saved a nice nest egg for your retirement, the best advice is to invest in liquid, transparent vehicles that you understand and stick to a long-term strategy. Don’t let the allure of hedge fund make you stray from a well thought out plan.
by Mitch Zacks, Senior Portfolio Manager
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