Four Questions to Consider BEFORE Investing in Hedge Funds

Date: Tuesday, April 17, 2012
Author: Rob Clarfeld, Forbes

In a world of low expected returns across most asset classes, it can be tempting for investors to search for ways to increase their expected returns by turning towards alternative investment strategies such as hedge funds.  The label “hedge funds” has become a generic description of the very broad universe of diverse strategies that tend to relax the typical portfolio constraints that are placed upon long-only investment managers.  The increased flexibility of hedge funds has led many to believe that they can provide better risk-adjusted returns over time, with less volatility than more traditional investment portfolios.  While there are many successful hedge funds, as a broad group, they are no investment panacea.  Investors who are tempted to invest in hedge funds should be aware that the potential for superior risk-adjusted returns does not mean that this promise, ultimately, will be realized.  There are a number of hurdles that need to be taken into consideration and questions that should be asked before committing investment dollars to the nebulous universe of hedge funds.  Here are a few considerations that should be considered:

1.  Is the fund’s strategy really different? Hedge funds utilize the typical array of asset classes as a means to construct their strategies.  While many hedge funds promise low correlations to traditional asset classes, and, therefore, claim to offer a unique diversifying addition to a traditional portfolio, in reality, many do not deliver what they promise.  Correlations and betas for most hedge funds tend to show a high consistency with the returns of the broad market of their chosen investments.  If you are already invested and have exposure to equity beta, you should be sure that your potential hedge fund investment is not just very expensive beta in drag.

2.  Does the hedge fund manager really have an analytical advantage? Hedge fund managers are dealing with most of the same issues as long-only managers.  That is, whatever the strategy they are executing against, they still need to be right!  Getting it “right” with a meaningful degree of consistency is always difficult, and much more so when outsized fees are considered.  Which brings us to…

3.  Is the promise justified by the fees? Hedge funds almost always charge much higher fees for their services relative to their traditional long-only counterparts. With a typical fee of 2%, and 20% of the profits above a high water mark, the fees paid to hedge fund managers are steep.  As we well know, the typical active manager has a great deal of difficulty consistently beating their passive indices after all fees are considered.  Given the steepness of the typical hedge fund fee, the performance hurdle is even higher.  While some hedge funds have been able to justify their high fees, there are many more funds whose outsized fees are not justified.

4.  When will I need my money? Hedge funds typically require that investors sacrifice liquidity in order for them to execute their strategies.  While the terms of each fund are unique, in general, investors are limited in their ability to withdraw funds at their own discretion.  While mutual funds, ETFs, and separate accounts provide daily liquidity, with the ability to convert investments quickly into cash, the more restrictive liquidity that is inherent in the nature of hedge funds is something that investors must seriously consider before investing.

Based on over 30 years of experience working with hedge funds of various stripes, my belief is that most investors are not getting the value they are seeking, and paying for, within the hedge fund universe.  Yes, we all hear of the very few managers who have been able to defy gravity over time; but, obtaining reliable data and strategic explanations that would enable one to predict which managers will continue to do well is challenging.  In today’s difficult investment environment, one should seek out diversification, transparency, low costs and liquidity – qualities rarely delivered by the vast majority of hedge funds.

For more information, visit www.clarfeld.com, or contact me at rob@clarfeld.com.