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Hedge Funds as Investment Diversification


  • Hedge funds have performed miserably in the last bull market but things might turn.
  • Fees are the deal killer as 2% of assets under management and 20% of profits eats up all the returns.

Introduction

There is currently a negative sentiment towards hedge funds as they mostly underperformed the market in the last 6 years. This article is going to elaborate on how hedge funds work and relate that to the current circumstances in order to assess investment possibilities.

What is a Hedge Fund?

A hedge fund is an alternative investment strategy that uses tools like derivatives and leverage. The goal is to achieve alpha returns (beat the market) while having a low correlation with the common stocks and bond markets. Therefore, hedge funds are considered good diversification. The name derives from the word “hedging” which is the practice of maximizing returns with reduced risk.

The catch with hedge funds lies in the unusually high fees, usually 2 and 20, which means 2% of assets under management and 20% of profits. In 2008, Warren Buffett made a bet with hedge fund Protege Partners, LLC that his simple S&P 500 fund would beat a hedge fund with a team of managers at the helm in a 10-year period if not for other than only the hedge funds fees (0.16% S&P 500 fund vs 2 and 20 hedge fund). After the initial 2008 scare Buffett can already celebrate his win and make the hedge fund donate $1 million to a charity of his choice as the S&P 500 fund is up 65.7% while the hedge fund is up only 21.9%.

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Figure 1: Protégé partners wager result at end of 2015. Source: Yahoo Finance.

Hedge Funds Historical Performance

But, in the long term it does not look that bad for hedge funds. From January 1990 to February 2016 hedge funds managed to outperform the S&P 500 with less volatility (prior of fees).

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Figure 2. Hedge funds, S&P 500 and bonds performance and volatility. Source: Bloomberg.

The above shows that hedge funds have a point but the fees remain the question as they eat up investors’ returns. The main contribution to the above returns was made in the nineties and since then hedge funds have underperformed as the market strongly marched ahead.

3 figure hedge fund perfrormance by strategy
Figure 3: Hedge fund performance by strategy. Source: Bloomberg.

There are several potential reasons for the poor performance. One is that there are too many hedge funds and not enough market inefficiencies to sustain a $2.9 trillion industry. Another reason is the nature of hedge funds: they are not supposed to be up when stock markets are up and seeing that the stock markets were mostly up, it is very difficult to outperform. Poor performance results in investors redeeming funds and further igniting the decline by forced sales of assets. But a bear market should give hedge funds a run for their money and give excellent diversification to investors that think the market is currently overvalued.

Going by the saying be greedy when others are fearful and be fearful when others are greedy, it should be a good time to be exposed to some hedging diversification. Considering that many investors have lost their patience, like the life insurer MetLife who is seeking to redeem $1.2 billion of its hedge fund investments due to poor performance, or American International Group (AIG) that is redeeming $4.1 billion due to three straight unprofitable quarters, it might be the correct time to invest in hedged investments.

Hedging Investment Opportunities

Of course, the first option is to directly contact a hedge fund but you have to be a sophisticated investor, and thus have more than $200,000 in annual income and a net worth higher than $1,000,000 excluding your home. There are also other possibilities that can give similar results with lower fees. One strategy is investing in alternative mutual funds that use a long/short strategy. There are also ETFs that try to replicate the hedge fund index performance. ETFs can only try to replicate because hedge funds do not always disclose their trading activities unlike the above mutual funds. Options are the ASG Global Alternatives fund, the Credit Suisse Multialternative Strategy Fund or the IQ Hedge Multi-Strategy Tracker ETF.

The third option is copycat investing by following the 13F forms filed to the SEC by hedge funds and following their strategy, albeit at a later point in time. An article about hedge funds would not be a good one without mentioning the notorious Carl Icahn, owner of Icahn Enterprises Limited Partnership (NASDAQ: IEP) of which units can be purchased on the open market by anyone. It is a good hedging opportunity as, according to the last report, the IEP had a net short position of 149% at the end of the last quarter. But, a warning must be issued here as the net asset value of IEP’s unit is around $38 while the unit price on the market is $57.

4 figure IEP perfromance
Figure 4: IEP unit performance in the last 10 years. Source: Yahoo Finance.

Conclusion

The easiest investing strategy would just be to follow Buffett’s advice and buy the S&P 500 and enjoy long term, steady returns correlated to the US and global economies. But, investors then must also be able to weather periods of increased volatility and bear markets. For the ones that would like more diversification and an opportunity to lower volatility and maybe even increase returns, hedge funds or hedge fund alternatives should be a good option.

 

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