Selection is essential when diversifying with hedge funds.
Risky. Underperforming. Expensive. To many investors, these are the words that come to mind when they hear the term “hedge fund.” But while these descriptions may be valid for certain funds, investors should resist dismissing the asset class altogether. Hedge funds may play an important role in a diversified portfolio. This is because while hedge funds do involve risk, access to certain funds offers the dual benefit of positive returns along with important – and rare – diversification. The key? Selectivity.
One common misunderstanding regarding hedge funds is that they are designed to offset other market exposures. Many investors are under the impression that when equities are down, hedge funds should be up. In reality, hedge fund performance is dependent on both the strategy of the fund and the manager. Although many strategies can be lumped under the banner of “hedge funds,” each fund can perform quite differently.
So, what is a hedge fund? Simply stated, hedge funds are managed portfolios that use unique investment strategies related to market inefficiencies, trading acumen or manager skill. Funds are designed around a particular investment outcome: these include beating a benchmark, mitigating volatility and/or providing exposure to asset classes not typically found in conventional portfolios.
Whether a hedge fund’s strategy involves applying manager skill to construct an equity long/short portfolio or sifting through vast quantities of data looking for exploitable opportunities, hedge funds are unique. And it is the unique attributes of certain funds that can make adding them to a diversified portfolio so valuable. For example, adding exposure to manager skill and/or to esoteric risk factors can provide a diversified portfolio the best of both worlds: the addition of a positive expected return and diversification. Properly selected, hedge fund exposure should be expected to have a low correlation to other assets in the portfolio, specifically conventional equity and fixed income.
Properly selected, hedge fund exposure should be expected to have a low correlation to other assets in the portfolio, specifically conventional equity and fixed income.
Hedge funds aren’t for everyone. First, they have high minimum investment requirements, which may range from $100,000 to $5 million or more. Typical hedge fund investors include pension funds, endowments, foundations, family offices and high net worth individuals. Second, because hedge funds are generally offered as private placements, requirements for hedge fund investors are more stringent than those for many other investments. Individual investors must meet criteria set forth by the fund and also the definition of an accredited investor, which includes:
- Annual income of $200,000 for the previous two years ($300,000 with a spouse) with a reasonable expectation of meeting this threshold for the current year; or
- Minimum net worth of $1 million, excluding the value of a primary residence
As they are often invested in illiquid assets, hedge funds can require longer lead times to raise cash for redemptions. So once funds are committed, a lock-up period may ensue. This means an investment is unavailable for redemptions for a pre-defined period of time, which may range from three months to two years or more. After that, it is common that invested funds can only be withdrawn at monthly or quarterly intervals with 30-90 days prior notice.
The compensation structure for hedge fund managers has historically included both a management fee and a performance incentive fee, meaning an investor pays one fee regardless of performance and another if profits are generated. Funds with this fee structure generally employ a high water mark, which means managers only collect the incentive fee when the fund exceeds its previous highest recorded value. In recent years however, this model has fallen out of favor with some institutional investors, and the industry has seen a slight migration away from it.
Hedge fund risks vary considerably across funds but are often higher or different than the risks associated with investing in more conventional bond and stock strategies. For example, many hedge fund strategies employ leverage (e.g., borrowing money to enhance return potential), invest in derivatives, and/or invest in illiquid assets. Plus, many hedge funds have higher fees relative to other actively managed investment strategies.
But the diversification benefits certain funds may bring to a portfolio can justify higher risks and/or fees. The key to using hedge funds effectively is to understand the type of exposure you will get by adding the fund to your portfolio, and assessing whether it aligns with your risk preferences and is worth the fee.
Examples of how hedge funds can enhance portfolio diversification include:
- Reducing the volatility of a portfolio heavily invested in equities;
- Adding return potential to a portfolio heavily biased toward lower-risk/lower-return fixed income investments; and
- Smoothing out returns in a diversified portfolio of stocks and bonds by aiming to retain value during market corrections and magnifying the effects of compounding over time.
Hedge Fund Performance During the 10 Worst Months for Global Equities (Jan 05 - Dec 18)
If you are considering investing in a hedge fund, start by discussing the following questions with your financial advisor.
- Do you need to diversify your portfolio to achieve your financial goals?
- What is your investment time horizon, and what are your near-term liquidity needs?
- What unique sources of return does each fund offer, and which provide the diversification benefit needed in your portfolio?
- Do you fully understand the strategy? If not, consider reaching out to your advisor for assistance.
Investors undoubtedly need to perform ample due diligence before investing in a hedge fund. With the right tools and a sharp focus on their proper role, however, hedge funds can be a valuable component of a diversified portfolio.