Making the Case for Hedge Funds: Why They Still Matter

Hedge funds – and their managers – are not new to vilification. The media has blamed them – for years – for the country’s economic inequality. Even the …

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Hedge funds – and their managers – are not new to vilification. The media has blamed them – for years – for the country’s economic inequality. Even the current presidential election has brought attention to hedge funds, with outspoken Republican candidate Donald Trump saying: “Hedge fund guys are getting away with murder.”

But looking closely, it becomes apparent that hedge funds simply aren’t given enough credit for what they’re intended to do: generate profits while controlling certain aspects of risk. An effective hedge fund manager will be able to deliver a range of returns within an acceptable spectrum of risk. Hedge funds certainly have their place in large portfolios where the owners can afford to lose. They are still very high risk investments and are best suited for those who have no apparent need for liquidity.

Preserve and diversify

Despite some assumptions by investors, hedge funds are not designed to automatically outperform the S&P 500. This assumption led to hedge funds being heavily scrutinized after 2014, where only a tiny percentage of these funds outperformed the market. But here’s the thing: many hedge funds have protections built in against downsides. These protections can, incidentally, negatively impact the level of upside performance experienced.

What hedge funds are designed to do is achieve capital preservation, reduce volatility, increase diversification, and achieve risk-adjusted returns. The degree to which hedge funds achieve these goals is dependent on the fund, fund managers, risk profile and historical performance. It is also true that past performance is not necessarily indicative of future results. Hedge funds hold some interesting historical performance metrics, however, that are worth repeating.

For example, during the last 18 years, the S&P 500 had 17 negative quarters (totaling a negative return of 113.01%). During those negative quarters, the average U.S. equity mutual fund had a total negative return of 115.7%. The average hedge fund had a total negative return of only 10.3%, demonstrating its ability to preserve capital in falling equity markets.

Gain an advantage

There’s no escaping the reality that any entity with the type of infrastructure and capital in place as hedge funds do are more capable of making the types of bold and well-timed moves that maximize profits. Individual investors struggle to compete.

When a hedge fund manager truly has an investors’ best interest in mind, s/he will establish a rather loyal investor following because, simply put, s/he will get results. Hedge funds are an unfortunate double-edged sword. While they can and sometimes do provide sheltered returns, they can cut more deeply in that their general risk/return profile is much too volatile. They’re only appropriate for large, liquid portfolios where the owners can afford to lose.

Don’t write off hedge funds just yet

It’s easy to rile up angst for an industry that personifies the 1% mantra being sung by politicians and media outlets. Yes, it’s true, with hedge funds a few folks end up generating billions of dollars in personal wealth.

Yet, despite all that, many institutions and people are still investing in risky private equity and hedge funds.

Over the past decade, the number of hedge funds has risen by roughly 20% per year, while the rate of growth in hedge fund assets has been even more rapid. There are roughly 8,350 hedge funds managing $1 trillion. Sure, the number and size of hedge funds remains small when compared to mutual funds, but their growth reflects their importance as an alternative investment option for institutional (and wealthy individual) investors.

Why is that? It comes down to results: the amount of capital that generates returns is enough proof that hedge funds are worth adding to one’s portfolio. In fact, all the funds included in Barron’s list of top 100 hedge funds have achieved 3-year annualized gains of at least 15%. A few have achieved between 40 and 50%.

With these types of results, hedge funds should still not be written-off completely. Keep in mind, that’s not investment advice, but simply a general observation. The investor “fit” for hedge funds is likely so narrow that most investors should steer clear of the “murderers.” They have their place in the spectrum of options.

Keep in mind: this is not investment, legal or accounting advice. Please consult with knowledgeable professionals for legal and investment advice.

 

 

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