The hedge fund industry is a fascinating and mysterious world. With smart strategies, the ‘rock stars’ of the financial sector aim to achieve stable returns with low risk, regardless of market conditions. With this, they pursue the holy grail of investing, namely ‘alpha’ (or high return with low risk). How do hedge funds operate, and is the asset class worth considering?
Although the first hedge fund was founded as early as 1949, their popularity was rather muted until the late 90s. Valued at more than USD 4 trillion by 2023, hedge funds are now an integral part of many institutional portfolios.
Hedge funds employ a variety of strategies to capitalize on market inefficiencies and future trends. In doing so, managers implement their vision by hedging market risks. To illustrate: a portfolio with a short position in Tesla and a long position in Volkswagen will make a profit if Volkswagen performs better, even if both stocks fall.
Hedge funds are distinguished from traditional funds by their flexible investment mandate. For example, they may use (i) debt financing, (ii) more complex financial instruments, (iii) short positions and (iv) maintain more concentrated portfolios. In short, the asset class has the potential to provide a valuable source of diversification across broader portfolios. Nevertheless, there are a number of practical challenges that investors should consider:
Decreasing Returns – Hedge funds delivered strong performances at the beginning of this century. However, as the industry continued to mature, the funds proved less able to exploit market inefficiencies. Stricter regulations have also potentially contributed to this trend.
High costs – In addition to high fixed management costs (1-2%), variable costs also apply for profits achieved (15-20%). However, the lack of ‘clawback’ provisions implies that this fee is a lot higher in practice (~50%). This has significant implications for net returns to investors.
Diversification (?) – Despite the large variety of investment styles and instruments, in practice hedge fund returns are highly correlated with equities (>80%). This reduces the potential diversification benefits for a portfolio.
Tail risks – The use of (financial) leverage increases the magnitude of profits, but also of losses. Historically, this has led to the bankruptcy of several hedge funds due to (initially) unforeseen risks.
Bluemetric Insight | In theory, hedge funds offer stable returns at low risk. However, in practice, there are several challenges that lower the attractiveness of the asset class. Research shows that the added value for long-term investors with a higher risk tolerance is limited. Industry growth and tightening regulation are important factors underlying these findings.
Nevertheless, it is important to take into consideration the diversity of strategies available for practical implementation. Certain portfolios may benefit from specific strategies. Additionally, the asset class can add value for investors with a low risk tolerance.
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