Accredited investors are attracted to hedge funds for a number of reasons, despite the fact that the funds are more costly to own than traditional investments. Moreover, they are less liquid and don’t provide the same level of transparency. Diversification is often the primary reason.
Hedge fund returns are non-correlated with the returns on traditional asset classes. In periods when stocks and bonds are underperforming because the markets are flat or losing value, hedge funds may outperform.
When that’s the case, gains from the hedge funds have the potential to offset losses in an investor’s portfolio, providing downside protection. Further, since hedge fund values aren’t driven by the same market forces as traditional investments, or subject to the same cyclical patterns, they tend to be more stable.
This volatility means a hedge fund can provide a stronger risk-adjusted return, or a return relative to the amount of risk it takes, as measured by its Sharpe ratio. It also means that including hedge funds in an investment portfolio may mean more consistent returns, though of course there’s no guarantee.
While many hedge funds take a balanced approach to providing positive returns, some fund managers take greater risks or use leverage to boost their profits. By committing a small amount of the fund’s capital to control large positions, they may realize significant gains. But they also expose themselves to larger losses.
While there have been some spectacular successes, there have also been some notable failures taking this approach. In recent years there have been a number of US Department of Justice prosecutions for insider trading, which lave resulted in prison terms, tarnished reputations, and prompted some fund closings or restructurings.
It’s worth noting, however, that no hedge funds have been identified as systemically important, whose failure could pose a risk to the economy, as some large US bank holding companies and non-banks have been.
Investors who are attracted to hedge fund strategies but either aren’t accredited or aren’t willing to commit as much money as a fund would require may consider investing in a fund of hedge funds. The fund owns shares in a number of hedge funds, which may be selected either because they take the same strategic approach or specifically because they follow different strategies. Either way, these funds offer more diversification than a single hedge fund as well as the potential for higher risk-adjusted returns. But they also add another level of fees, as all funds of funds do.
Retail investors may also consider investing in one or more alternative ETFs. Unlike hedge funds, ETFs can be bought and sold on a national exchange at any time, at a price determined by supply and demand.
The fees are substantially lower than hedge fund fees, though higher than those of ETFs tracking broad market indexes. And there are no income or net worth standards or required minimum investment amounts. Some of these ETFs attempt to replicate a hedge fund’s portfolio by investing in the assets a fund reported in its most recent 13F filing. Others identify the types of investments a hedge fund is making based on the way it performs and then invest to achieve similar results using liquid assets. A third type invests to produce the same return as a hedge fund index, such as an equity hedge fund index or an index that tracks the number of hedge funds using different investment strategies.
Alternatively, investors’ brokerage accounts may include an allocation to a feeder fund linked to a hedge fund. The combined assets of a number of individuals meet the investment minimum. Feeder funds also carry substantial fees and may be less transparent than a fund of funds.
Hedge funds provide potential investors with a document called an investment memorandum, which explains the fund’s structure, identifies its strategy, and describes the qualifications of the management team. It can be a useful starting point in researching the fund, but it’s only the beginning of what you need to know.
First and foremost, you need to understand what the fund does—ideally well enough to be able to explain it to someone else. You will want to learn more about how complex or straightforward the manager’s investment strategy is, including the plans for using leverage, short selling, and derivative products. It’s also important to know how the fund is organized, how large it is, how many investors are participating, the amount that insiders have invested, and the identity of the fund’s independent accountant and other service providers.
Due diligence also includes background and regulatory checks on the fund’s managers and on any submanagers whom the fund may use to run parts of the portfolio. If the investment adviser is registered with the SEC, you can check Form ADV here.
You should also confirm the fund’s policy on share redemptions, including the lock-up period that may apply, the redemption fee, if any, and whether or not redemptions can be suspended. And you should ask how the fund values its assets and determines its performance. There is no standard method, as there is with traditional investments.
In reality, researching a hedge fund—or any other privately offered investment—is a job for an objective third-party analyst. Finding one is something you should discuss in detail with your investment adviser or brokerage firm.
Hedge Fund Investing. Due Diligence and Retail Investing by Inna Rosputnia
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