The Potential of Hedge Fund Returns: Evaluating Risk and Reward

Who Invests in Hedge Funds and Why?

Hedge fund returns are nearly as big as hedge fund investors’ grandiose reputation. Fund giants, such as Bridgewater Associates, topped LCH Investments 2019 list of profitable hedge funds with a whopping $150 billion in assets under management, including a net $8.1 billion gain in 2018. Unfortunately for hedge funds, the larger they are, the harder they fall, as evidenced by major funds like Criterion Capital Management and Highfields Capital Management, which were forced to closed their doors in late 2018.

Hedge funds are somewhat complex in definition. Funds are made up of partnering investors looking to get large returns in any market, good or bad, thereby making alternative and often risky investments, including distressed assets. The opacity, relative freedom from regulation, and “black box” investment strategies only adds to the mystique of the industry.

What’s in it for individual investors? No doubt about it, many investors have done well by diversifying into hedge funds. Even those who have done poorly nevertheless earned the right to gloat over their hedge fund positions down at the country club and in the skybox at halftime. For some adventurers, losing money in a hedge fund is not as shameful as never investing in one at all. Excitement and status can be powerful incentives even for accredited investors, although we hope that your incentive is old-fashioned ROI.

Back Down to Earth

In this article, we will try to bring the hedge fund investment class down to earth and into sharper focus, with potential hedge fund returns as our guide instead of excitement or status.

Who Invests in Hedge Funds?

In the early days of hedge funds — the 1950s through the 1980s — outside investors (other than the fund managers themselves, who typically invested a significant portion of their own wealth in their funds) were mostly wealthy individuals and family offices. Since then, institutional investors (predominantly public and private pension funds, but also insurance companies, charitable foundations, university endowments, etc.) have gradually diversified into hedge funds.

Since the global financial crisis of 2008-2009, new capital coming into the industry has been predominantly from institutions, according to KMPG and the Alternative Investment Management Association. Today, there are roughly 5,500 institutional investors active in hedge funds, with nearly 75% of investors located in the United States.

Caveat: Because of the opacity of hedge funds and relative lack of reporting, statistical data and industry performance results may vary, and different research firms often produce conflicting figures.

Hedge Fund Returns and Rewards

Given the recent ebb of individuals from the hedge fund asset class, and the fact that 2018 was a bad year for the industry (with hedge funds down 6.7% compared with a loss of 6.2% for the S&P 500 by December), well, do you have to be crazy to consider investing in a hedge fund in 2019?

Let’s consider the benefits and rewards first, then the costs and risks. Here are the four primary reasons to invest in a hedge fund, aside from bragging rights:

1. Absolute return. Conservative hedge funds, which invest in alternative assets (uncorrelated with the equity and bond markets) and/or take offsetting short and long equity positions, aim to make money from falling as well as rising markets.
2. Shelter from volatility. Most hedge funds aim to provide diversification for portfolios dominated by traditional investments, moderating risk, and volatility. (Not all hedge funds aim to reduce volatility, however; some, like those that place large, highly leveraged directional bets, aim aggressively for monster returns.) In fact, hedge funds had nearly 8% less volatility than the S&P 500 in 2018, despite negative returns for the year.
3. Superior management talent. High management fees (typically 2% of assets under management and 20% of gains each year) and relatively unfettered investment styles attract experienced, successful investment talent from large banking and money management firms to the hedge fund industry. Unfortunately, past success is no guarantee of future performance.
4. Dramatic overall returns. Yes, there are investors who just want to make a killing and believe that certain kinds of hedge funds offer the best risk/return profile for that purpose. Those that use leverage are able to magnify returns (as well as losses). In any given year, a few funds produce high double-digit returns (and some in the low triple digits); some build impressive, long-term double-digit records — such as Paulson Credit Opportunities, which cleaned up by betting against subprime mortgage-backed securities during the financial crisis.

Long-term successes like Paulson are rare, however. From 1980 through 2008, the average hedge fund return showed an annualized 6.1% after fees, compared with 10.8% for the S&P 500.

Be careful whose statistics you rely on. Despite media hype around the most successful funds, “the body of historical evidence demonstrates that once viewed on a risk-adjusted basis, the average hedge fund has a hard time keeping pace with Treasury bill returns,” says Larry E. Swedroe and Jared Kizer in “The Only Guide to Alternative Investments You’ll Ever Need.”

According to a 2018 Preqin survey, 80% of investors vowed to maintain or increase their allocations in hedge funds, citing diversification and reliable returns over time as their reasoning.

Hedge Fund Risks and Costs

Funds that primarily make big directional bets, rather than aiming to reduce volatility, pose the greatest risk to investors. Other costs and risks include:

1. High barrier to entry. You need money to make money, meaning to see hedge fund returns, you have to have the capital. Each fund sets a minimum investment amount, although the fund manager may waive the minimum at their discretion. In general, accredited investors must have a net worth of $1 million and make at least $200,000 in annual income. For hedge funds, this minimum may be much higher, with average hedge funds requiring $1 million minimums. Larger funds may start around $5 million to $10 million. (Funds of hedge funds usually have lower investment thresholds.) Of course, this high barrier makes hedge fund investors members of an extraordinarily elite club, and who’s to say that in itself is not worth the price of admission?
2. Loss magnified by leverage. Unless highly leveraged bets are effectively hedged, they can result in catastrophic losses (or spectacular gains). According to a 2011 report by the National Bureau of Economic Research, the average leverage for hedge funds is between 1.5 to 2.5, which is actually low compared with the average leverage for investment banks of 14.2.
3. Short risk. Taking short positions in equities may help to hedge a portfolio, but it also creates unlimited downside, because prices can rise without limit. It also incurs borrowing costs.
4. Illiquidity. In some funds, the initial investment may not be redeemed (the capital is “locked up”) for a specific period, such as a year. After that, investors’ ability to redeem their capital is generally restricted to a narrow window each quarter or each year. In certain critical circumstances, investors’ capital may be frozen for longer periods (by restrictions known as “gates”) to give fund managers more strategic flexibility. In addition to the illiquidity of the fund itself, fund managers may invest in illiquid securities.
5. Non-disclosure and fraud. Because hedge funds are lightly regulated, there is a greater chance of fraud than in the tightly regulated securities markets. Since hedge funds do not have to comply with the strict SEC disclosure rules that govern the public securities industry, their operations are relatively opaque — sometimes for good reasons (e.g., so competing funds can’t duplicate their strategies or bet against them). But such opacity makes it easier for managers to conceal losses or exaggerate reported profits in order to hike their fees. (All fund investors do receive annual financial audits, for tax purposes. Fund managers usually give their investors periodic performance reports, but they’re not required to do so.)
6. Investment in risky assets. Opportunistic fund managers may invest in almost any asset, anywhere. Distressed debt investments are popular because the debt can be purchased at a discount and sold with potentially large returns if the distressed company bounces back. Of course, it’s not guaranteed that the distressed company will bounce back.
7. Attrition risk. If a fund collapses, investors may have a hard time getting capital back out. A 2005 study by Burton G. Malkiel and Atanu Saha found that less than 25 percent of the funds in existence in 1996 were still alive in 2004. The average lifespan of a hedge fund is closer to that of a fish than a tortoise, often just half a decade. The history of hedge funds is littered with brilliant managers who managed, even without defrauding investors, to crash and burn brilliantly.
8. Agency risk. When a manager approaches the end of the year and has failed to reach the benchmark level above which he or she earns incentive compensation, he or she has an incentive to take large, even desperate risks to surpass the benchmark in a very short period. Whereas managers earn a percentage of gains (over and above the benchmarks), they are not exposed to losses. Conversely, investors take all the downside risk but do not participate fully in the upside.

Do You Need This Excitement?

Back to the question – whether or not to invest in a hedge fund. The answer is, of course, it depends on your net worth, what’s in your portfolio already, long- and short-term goals, risk profile, liquidity needs, and other factors. Because of the high barrier to entry and the formidable risks, don’t make this decision without consulting a professional investment adviser who is experienced in accredited investor markets.

If you are still considering such an investment, the next steps are to (a) select a short list of funds that use investment strategies that are consistent with your portfolio needs, (b) conduct due diligence, and (c) before you select the fund to invest in, consider a fund of hedge funds to diversify the risk. And remember: focus on the potential hedge fund returns rather than the recognition or status.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Opportunity Amidst Crisis – Buying Distressed Assets, Claims, and Securities for Fun & Profit and Advanced Investing Topics: Unicorns and Pre-Unicorn Scalable Private Company Propositions. This is an updated version of an article that first appeared on February 2, 2013.]