Hedge fund strategies are beginning to see renewed interest from institutional investors seeking diversification benefits and downside protection. But these strategies can be complex and involve a variety of public and private assets, as well as derivatives, and require paying incentive fees. This complexity can potentially add unique risks such as liquidity, transparency, and leverage, many of which are not usually present in traditional equity and fixed income investments.
Given these issues, I wanted to provide this hedge fund explainer so that investors can be educated about the pros and cons of investing in these strategies. They are not the right solution for all investors, and learning about them can properly prepare the board and staff of an institutional investor to make that judgment. When considering investing in hedge funds, investors should also assess whether the added complexity is worth the diversification benefit that a hedge fund program brings to the overall portfolio. In addition, investors should consider potential customization options available in structuring a hedge fund program, depending on their mandate size and program goals.
For institutional investors that have the ability and willingness to build a direct hedge fund portfolio, we favor multi-strategy hedge funds as a core allocation in a direct hedge fund portfolio. They have the ability to allocate dynamically across strategies without the involvement of the investor. In addition to multi-strategy funds, we favor satellite allocations to strategies that have lower betas to traditional equity and fixed income indices. The types of hedge funds that have those traits, and have the ability to generate returns somewhere between equities and fixed income, include:
We are less favorably disposed to strategies exhibiting high and persistent beta exposures (long-biased equity or credit), concentrated or highly levered standalone niche strategies (convertible-only, mortgage-only, credit-only, regional or sector-only equity), and concentrated macro strategies, whether discretionary or systematic.
Management fees for hedge funds tend to be in the range of 1%-2%, and performance fees tend to be in the range of 15%-20%. Most hedge funds have a high-water mark, which means managers are unable to collect performance fees after a negative year until they get back that negative return. Some strategies also use a different performance metric and have a hurdle rate, which means that they cannot collect a performance fee until performance goes above that level. A common hurdle rate reflects 90-day T-bills + a fixed rate.
Operating expenses are another fee that institutional investors need to be aware of. These typically include legal fees and audit and tax expenses incurred by the fund and passed on to investors. Operating expenses are not listed by hedge funds; instead, investors have to review their audited financial statements to see the amount of expenses charged to the fund.
For relevant benchmarks, two of the most common are the HFRI suite of indices and those produced by Credit Suisse. The broadest are the HFRI Fund-Weighted Composite Index and the Credit Suisse Hedge Fund Index, but both companies provide numerous indices for specific strategies. Investors can also use long-only indices to measure hedge fund performance, such as a quarterly rebalanced 60%/40% blend of the MSCI ACWI Index and Bloomberg US Aggregate Bond Index.
Properly selected, hedge funds offer several benefits. For example, Callan views hedge funds as diversifiers. The primary objective of most hedge funds is to provide superior risk-adjusted returns with low correlations to traditional asset classes (stocks, bonds, and real estate). Hedge funds achieve this by using a broad array of strategies to make investments in mispriced securities regardless of size, style, or other sector classification. Hedge funds also can provide downside protection when broad markets sell off in times of stress. When market volatility becomes elevated and dispersion is higher, hedge funds have a track record of being able to generate alpha.
Hedge funds can also help U.S. institutional investors with the long-biased exposure they have in their portfolios to both equities and fixed income by adding diversification, because they can go both long and short across multiple asset classes. Hedge funds have shown the ability to opportunistically allocate capital as different markets become more or less attractive.