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Should Families Invest in Hedge Funds?

June 29, 2020
“Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood. They are generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut.”- Cliff Asness

Much of the above description is fair – which means the average hedge fund should probably be a pass for the average family. And given this not so compelling description, you will be unsurprised to hear that when compared to a traditional 60% stock / 40% bond portfolio, the average hedge fund under-performs – both absolutely and on a risk-adjusted basis (click here for more on this).

So while pass is likely the correct call here on average, the good news is that none of us live average lives – and we also do not experience average outcomes in our investment portfolios. For wealthier families that can access managers and strategies that are truly best in class, hedge funds offer the potential to improve risk-adjusted portfolio performance.

So if you have the means to sort the wheat from the hedge fund chaff, what is reasonable to expect from these strategies? And what benefit can they bring to your portfolio?

Net of fee returns in the mid to high single digits – and with relatively low correlation to stocks and bonds would be a success. And some strategies, while they may be more volatile, have the potential to produce attractive returns when other parts of the portfolio are getting clobbered (i.e. they have negative correlation to other strategies and asset class exposures).

As you might imagine, the dispersion of returns across the hedge fund universe is wide – which makes discussion of average performance less useful. And this makes sense for a group of investment strategies that are dependent on a manager’s ability to identify and exploit very specific opportunities – compared to more traditional strategies whose performance is largely dependent on what happens in financial markets (i.e. did the US equity market go up or down over a particular period).

Return dispersion has tended to decrease as fund size increases – with the range in annualized performance being about 8% annualized for smaller funds - decreasing to 6% annualized for the bigger funds[¹]. These are big ranges - and much wider than has been the case for equity mutual funds, where so much of the return is dependent on how the equity market has performed. So while picking the wrong equity mutual fund may hurt a little on a relative basis, picking the wrong hedge fund manager or strategy can hurt a lot!

One of the reasons that dispersion of returns for smaller managers is higher is because many hedge fund strategies use leverage. More broadly diversified portfolios generally contain less risk – which can allow more leverage to be used than would be prudent with less diversified portfolios. The opportunity here is for well-diversified portfolios with leverage to offer higher expected returns than poorly diversified, unlevered portfolios that contain the same risk (see here for more on this).

And just as the absolute return dispersion of hedge funds is wide, so too is the diversifying impact of different hedge fund strategies on portfolios – with one study[²] showing that a 20% allocation to the most diversifying hedge fund strategy types (i.e. added to a traditional 60% stock / 40% bond portfolio) would have had the following impact:

  • Improved the portfolio return a little (from 7% to 7.3% annualized);
  • Reduced portfolio volatility a little (from a standard deviation of 8.7% to 7.0%); and
  • Reduced maximum portfolio drawdown from 14.4% to 8% - that’s a meaningful improvement!

As you might expect, this study also showed that allocating to other hedge fund strategy types resulted in risk-adjusted performance that was worse than sticking to the traditional 60% stock / 40% bond portfolio. So again, strategy type, proper due diligence and portfolio construction is really important for hedge funds!

So… getting back to the original question, while hedge funds are not for most investors, they can add value for families that can access thoughtful advice, thorough due diligence and best in class managers. And while they are not likely to be the highest returning strategies in your portfolio – and you will not always feel good about owning them for all the reasons that Mr. Asness highlights, this is OK. After all, the most robust portfolios have allocations to as many nooks and crannies of the capital markets as possible and to the widest practical range of strategies, brain cells and market experience.

Being properly diversified means you have thoughtfully cast your investment net – with the expectation being that while all elements should do well over time, they should not all be firing at the same time. You should always be “comfortably uncomfortable” with some of the strategies you own – whether they are hedge funds or not…


[¹] Ranges are between the 25th and 75th percentile funds - see here for more on this

[²] per REFRESHER READING 2020 CFA PROGRAM • LEVEL III • READING 26 - Portfolio Management - Hedge Fund Strategies by Barclay T. Leib, CFE, CAIA, Kathryn M. Kaminski, PhD, CAIA, and Mila Getmansky Sherman, PhD – Data referenced above is from 2000 to 2016