Are Hedge Funds Really Worth It?
By Bailey McCann
If you read financial media these days, the argument on hedge funds goes something like this – they’re overpriced, they’re lagging the S&P 500 and investors should be wary. They should be warier still of hedged retail offerings for the same reasons. If you just look at performance numbers over the past five years, it’s hard to refute that logic. Hedge fund managers will tell you that a lot of the recent performance drag can be attributed to the lack of volatility and erosion of the short rebate in today’s market, but it is still possible to generate alpha. The fact is both camps are a little bit right. Confused yet? Let’s unpack what’s going on here.
According to the latest performance data through the end of March 2014, hedge funds have just posted their worst performance in nine months. Ouch. So what gives? At a macro level, Chinese weakness, political unrest in Ukraine and generally wobbly economic data coming out of the developed economies isn’t helping hedge funds much. Pre-quantitative easing, investors might have seen significant volatility spikes surrounding these events, but the effort of central banks to stimulate markets and force a smoother ride is eroding some of that volatility. On the other side of this, hedge funds themselves are unwinding some of their most popular trades, facing margin calls and other capital requirements as markets shift from growth oriented plays to value plays.
On a short-run basis this accounts for much of the current lag in performance. Going back over the past five years, lags there can be explained by some of the same trends like macroeconomic weakness, and quantitative easing along with a lack of volatility which makes it more difficult to go long and short.
Essentially what we’re seeing in real time is hedge fund managers try to figure out how to trade this market, and that gets messy. Why? Because unlike their long-only brethren hedge fund managers have more options in terms of how they approach a trade. Traditional mutual funds and other investments that you might’ve learned from through your retirement planner typically only take long bets – meaning they only expect a market will go up. In that instance, as long as the market goes up you see returns. Once the market dips or corrects, you either sell to avoid losses or you hold, take the losses and hope to make them up on the next rally. Hedge fund managers can take both sides of a trade placing long bets for the rally and short bets for the correction.
On the surface it may seem like hedge funds should consistently outperform the market if they can do that, but, that’s an oversimplification. The overall performance of any given fund is going to depend more on which side of a trade they take, how long they hold on to those bets, and whether their assumptions are correct. That’s where the personal skill of a hedge fund manager comes into the mix over and above basic market positioning. If markets are manipulated, as they are now, and fundamental or technical analysis doesn’t account for all of what’s going on, investors are more likely to see drops in performance.
Passive vs. active management
Traditional investing strategies often come with what they call a ‘buy and hold’ mentality. Like those RonCo infomercials – just “set it and forget it” is a common refrain for IRA contributions and savings through mutual funds. Even today in the wake of 2008, this viewpoint persists. The idea isn’t wrong per se – most investors will still see a compounding return on what they put in. But, there is also a strong case to be made for active management and hedged investing.
Putting part of your investible dollars into hedge funds and liquid alternatives can be a good way to bring more diversification into your portfolio. Briefly, the difference between hedge funds and liquid alternatives: hedge funds require a certain level of verified income, whereas liquid alternatives offer hedge fund strategies in a mutual fund structure and are open to those of us who still go to work every day. Liquid alternatives also allow you to get into and out of a fund as needed like you would a mutual fund. Hedge funds will require notice before an exit.
Consider this scenario; you invest in two blue chip mutual funds. Odds are if both of these funds are top performers, they have highly correlated or even the same positions. This means you get double the win in a rally but more importantly, double the loss in a correction. Allocating to the top mutual fund, and the top liquid alternative or a hedge fund means you’ll have some short bets in there or dynamic beta overlays through the alternative fund that you won’t get otherwise. Those funds are also actively managed so they’ll rebalance around current market positions, which isn’t always the case in a traditional fund that’s either in or out. So, when things correct you can mitigate some of your losses without just having to sell into a panic. This is an actively managed portfolio in action.
Alternatives critics will tell you that the fees for this type of management are too steep for limited benefit. Liquid alternatives will let you avoid some of that, but you could also argue that steep losses from passive investments aren’t saving you much money either. It’s important to understand your own investing goals, as well as the strategies you can use to get there. Ultimately the tactical play for any market is education. No one asks about hedge funds when they put up 20% returns (though they should have), but everyone is sure they’re wrong when they only post 7%. For investors, learning how to craft portfolios around objectives and scenarios like the one outlined above, is critical whether you go with a traditional or alternative fund. My goal with Tactical Portfolios is to walk you through the basic strategies in order to help you constructive a more responsive portfolio and avoid diversity in name only. Are hedge funds really worth it? That’s up to you.
Bailey McCann is the Author of Tactical Portfolios: Strategies and Tactics For Investing in Hedge Funds and Liquid Alternatives. She is also the Senior News Editor for Opalesque’s Alternative Market Briefing , a daily newsletter offering premium news and information service to alternative investment funds and their investors.