Solving the Hedge Fund Mystery
Yesterday in the New York Times in a post titled A Mystery in Hedge Fund Investing, Carl Richards wondered why anybody in the world is still willing to invest in hedge funds. It’s a very good question. The top argument against hedge funds, as he immediately points out, is their alarming underperformance last year versus the S&P 500. The Barclay Hedge Fund Index returned 2.88 percent, while the S&P gained over 13 percent.
Sure, that’s only one year, and the author acknowledges as much, but it’s still a jarring number. And going back to examine a decade of hedge fund returns against a 60/40 stock/bond portfolio doesn’t make hedge funds look any better. They underperform in that comparison as well, and were collecting often hefty fees the entire time.
Full disclosure: I work for a hedge fund, but I’ve only worked here for a few months. Prior to joining, not only would I have asked the same questions as Richards, but I also would have agreed with him. “What’s up with these rich people?” I might have wondered, as I watched my Vanguard funds trounce their fancy underperforming investments.
But having been in this world for a short period of time, I’ve come to understand what hedge funds can offer that index funds often can’t.
First, it comes down to trusting an individual versus trusting everybody.
When you own an index fund — which the majority of investors should — you put your faith in the lawmakers, CEOs, and citizens of the global economy. The indexes rise and fall on the news of the day, and their performance is a reflection of decisions being made by decision makers around the world.
Putting your faith in these decision makers has proven to be a sound investment. And for individuals like myself with relatively modest funds to invest, they make the most sense.
But if you have a net worth of millions, you may have a difficult time sleeping well at night knowing that the preservation and appreciation your considerable wealth is being dictated by the whims of central banks, the U.S. Congress, the health of the job market or the global consumer.
What might feel far better is knowing that your money is being managed by a single individual, or collection of individuals, whom you know, like, and trust.
One of the most important factors investors consider when selecting a hedge fund is the manager behind the fund. Yes, performance matters, and preference of strategy and asset class matters as well, but the individual behind the strategy and performance is often the deciding factor.
Another reason that individuals put their money with hedge funds is to provide an uncorrelated vehicle for returns in all variety of market conditions. Chances are that hedge fund investors also own index funds, as they should. They’re merely allocating a certain percentage of their risk capital to a hedge fund, which, in theory, can outperform in down market cycles.
This is where that word “hedge” comes into play. There are plenty of long/short funds out there, but loads of hedge funds deal in alternative asset classes which perform in a completely different manner than stocks and bonds.
Managed futures, for example, were the top performing fund asset class last year according to Barclay Hedge. The Barclay BTOP50 Index returned 12.2 percent in 2014, while the Barclay Hedge Fund Index returned that aforementioned 2.88 percent.
The average investor doesn’t even know what managed futures are, and nor should they. All they need to find is a manager they trust who deals in this asset class, and they can sleep well knowing they are, in theory, hedged against market downturns.
Of course, that’s just a theory. Most funds, including ours, lost money in 2008.
A final point is that hedge fund investors are usually already rich, and don’t need to see 10 percent annual returns in order to watch their nest egg grow into something they can put their kids through college with and hopefully retire comfortably upon. Capital preservation and modest returns may be enough for someone already worth tens of millions.
