With over $3.6 trillion invested in the hedge fund industry, hedge funds are notoriously big business. Synonymous with lavish Wall Street antics for several decades, hedge funds have long been the most misunderstood asset class in finance. The name is typically the source of most confusion here.

While some hedge funds implement sophisticated strategies to help hedge the market, most of these so-called “hedge funds” are not based around a specific hedging strategy.

Hedge funds are pooled funds, aiming to make money irrespective of the prevailing market conditions by pursuing investments that are outside the traditional long-only portfolios of equities and fixed income.

Hedge fund managers have discretion to use more aggressive trading strategies, with the option to invest across stocks, bonds, derivatives, options, commodities, or even other hedge funds. They may invest long, short (benefits as prices fall), or a combination of both.

Many of these strategies have a low correlation to traditional stocks and bonds, which can help improve overall portfolio return potential compared to more traditional-only portfolios.

Benefits

Flexibility

Unlike mutual funds, the unconstrained investment approach offers hedge funds managers the opportunity to generate positive returns in both rising and falling financial markets.

Diversification

As mentioned previously, diversification is a crucial aspect of portfolio construction. Hedge funds can produce a return stream with a low correlation to traditional assets, thus lowering the portfolio’s exposure to general market movements.

Return Potential

There are not as many regulations on hedge funds when compared to other investment opportunities, such as mutual funds; this provides hedge fund managers with more investment options. As a result, hedge funds have the freedom to implement more aggressive investment options across a broad spectrum of products to capitalize on opportunities as they arise.

Drawbacks

Higher Fees

Higher fees are the most often cited downside to hedge funds. Most hedge funds have a “2 and 20” fee structure. In this structure, investors pay a 2% management fee for operations of the fund and a 20% performance fee for any profit above a pre-agreed hurdle rate.

Less Liquidity

Hedge funds sometimes invest in illiquid assets. To account for this, they often have lock-up periods or longer redemption notice periods relative to more traditional public securities.

Less Transparency

Most hedge funds are not subject to the same disclosure requirements that apply to mutual funds as they do not advertise publicly. This lack of transparency can make it more difficult for investors to see exactly how their money is being invested.

The Future For Hedge Funds

A decade of central bank support has resulted in record-low interest rates and the longest bull market in history. This low volatility, utopian environment has favoured cheap index-tracking funds and made life difficult for those pursuing more complex, expensive strategies.

For years, hedge fund managers have longed for an uptick in market volatility, promising outperformance and downside protection once markets eventually falter. With volatility and uncertainty now at the forefront of the investment landscape once more, is a comeback on the cards for hedge funds?

Hedge funds have lost ground to passive balanced investments over the past decade

Generally, hedge funds are run by some of the best and brightest investment managers in the business. While the fees can often seem high, the recent market volatility may well coincide with the re-emergence of higher returns for the best performing hedge fund managers.

Interest certainly seems to be picking up. Forty-four percent of hedge fund investors surveyed by Preqin in June 2020 said they intended to increase their commitments to hedge funds over the next year, nearly double the proportion from a year ago.

No doubt, this increase in market interest is reassuring, and several hedge funds have seen performance soar due to the pandemic-induced volatility. However, other strategies have suffered the opposite fate. The challenge for all investors is, and always has been, separating the hedge fund managers that excel over time from those that don’t.