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.
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.
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.
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:
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.”
Funds that primarily make big directional bets, rather than aiming to reduce volatility, pose the greatest risk to investors. Other costs and risks include:
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.]
David M. Freedman retired in 2016 after 40 years as a financial and legal journalist. He is a coauthor (with Matthew R. Nutting) of Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, NY, 2015). He also wrote Box-Making Basics, a woodworking book (Taunton…
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