While most people will agree to hold traditional assets like stocks and bonds in their portfolios, hedge funds are more controversial. I usually recommend sticking to stocks and bonds. This post outlines some observations that support my position in the final of the three-part series.
The return is not big
The best hedge fund managers are probably skilled. Research shows that hedge fund managers created up to $600 billion in added value between 2013 and 2019. However, this added value was calculated prior to the fee. This figure is much lower as the fee network captures most of the value that managers create and leaves investors with breadcrumbs. A group of researchers recently found that hedge fund fees account for 64% of total revenue.
Most studies reveal hedge fund returns, particularly mediocre after 2008. There is no way to predict whether a higher performance than observed before 2008 will recur. Some observers argue that rising managed assets make it difficult for hedge funds to implement, as hedge funds reduce returns of size, but there is limited evidence. Overall, the best hedge fund managers may have the skills, but that doesn't necessarily lead to significant returns for investors.
Also, the value to consider is the fact that hedge funds generally offer modest returns, but investors tend to fall largely below the funds they hold because they are inadequately timing of inflows and outflows.
The benefits of diversification are limited
Adding hedge funds to your equity and bond portfolio can improve risk-adjusted returns, as measured by traditional metrics such as Sharpe ratios. However, hedge fund returns have been declining significantly since 2008, so replacing some of the equity components of the portfolio can result in undesirable performance.
Additionally, hedge funds have an asymmetric fee structure. Managers receive performance fees when the fund makes a profit, but do not need to compensate the fund when it loses money. Such a fee structure could induce some hedge fund managers to adopt strategies that provide regular, modest benefits at the expense of occasional sudden losses. In other words, many hedge funds are more risky than they are displayed.
The price is too high
I think hedge fund fees are scary. Paying performance fees above the already expensive 1.5% average base rate is bad enough, but 86% of hedge fund performance fees are not subject to the hurdle rate. There is no benefit to winning returns that exceed the base fee alone.
Additionally, a third of hedge funds do not have the high-water mark feature to prevent managers from charging performance fees for lost funds. However, even with the high-water mark feature, investors can pay performance fees for poor revenue funds if deep losses continue to follow initial success.
For investors looking to invest in diversified hedge fund solutions, the funds will increase costs in the second rate tier than the second rate for each component. Another problem arises when investors hold a diverse pool of hedge funds and acquire and lose funds. The winning fund may legally charge performance fees, but the lost funds will totally reduce the total pool of profits generated by the hedge fund portfolio.
As a result, investors can pay a rate much higher than contractual performance costs. A study examining a pool of almost 6,000 hedge funds found that while the average performance fee for this pool was 19%, investors paid almost 50% of the total profits on total funds.
Complexity isn't your friend
Hopefully, the series has convinced hedge funds that they are far more complicated than basic stocks and bond funds. Research has demonstrated that financial companies can increase profit margins by intentionally creating complex financial products. Complex products create information asymmetry, allowing highly informed financial companies to negotiate from their strength status with relatively low-informed clients.
Financial companies can make complex products look attractive by leveraging investor cognitive biases such as myopia loss aversion, the impact of modernity, and overconfidence. As economist John Cochran once said, “The financial industry is 100% of the marketing industry,” investors should be careful.
Attempts to predict outperformers probably fail
The research suggests that manager ownership, strategic characteristics, or characteristics not listed in the commercial database may help identify winning hedge funds. However, any filtering strategy could generate dozens or hundreds of candidate funds to choose from. These candidates include some false positives. For example, Swedroe (2024) highlights that a small number of outperform funds have a significant impact on the positive alpha observed in unlisted funds.
Also, most hedge fund literature does not help short-term investors' fund selection. Even if you choose a good hedge fund, it doesn't necessarily mean you will accept money from you. Many choose to work only for large institutions, while others reject new capital as they have reached full capacity to generate alpha.
Finally, even some of the most resourceful investment organizations have given up on hedge funds. In many cases, they were unable to find expensive alphas, which made them unable to justify the high prices, opacity, and complexity.
Personal experience
Other reasons to avoid hedge funds come from personal observations.
Financial success relies on disciplined savings and investments, not flashy investment products or high returns.
Investors suggest they are not very good at attracting active fund managers and have not seen evidence that hedge fund selection is easy.
Investors often build and preserve wealth, as they feel “good enough.” In contrast, if investors increase the risk of a portfolio to “a little more return,” losses can occur. This is especially true when working with opaque and complex investment products.
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Part I/High Ads: Do hedge funds provide value?
Part II / Beyond the Marketing Pitch: Understanding the Risk and Returns of Hedge Funds
