Hedge Funds: Higher Returns or Just High Fees?

Unlike mutual funds, hedge fund managers actively manage investment portfolios with a goal of absolute returns regardless of the overall market or index movements. They also conduct their trading strategies with more freedom than a mutual fund, typically avoiding registration with the Securities and Exchange Commission (SEC).

There are two basic reasons for investing in a hedge fund: to seek higher net returns (net of management and performance fees) and/or to seek diversification. But how good are hedge funds at providing either? Let's take a look.

Potential for Higher Returns, Especially in a Bear Market

Higher returns are hardly guaranteed. Most hedge funds invest in the same securities available to mutual funds and individual investors. You can therefore only reasonably expect higher returns if you select a superior manager or pick a timely strategy. Many experts argue that selecting a talented manager is the only thing that really matters.

This helps to explain why hedge fund strategies are not scalable, meaning bigger is not better. With mutual funds, an investment process can be replicated and taught to new managers, but many hedge funds are built around individual "stars," and genius is difficult to clone. For this reason, some of the better funds are likely to be small.

A timely strategy is also critical. The often-cited statistics from Credit Suisse Hedge Fund Index in regard to hedge fund performance are revealing. From January 1994 to June 2023—through both bull and bear markets—the passive S&P 500 Index outperformed every major hedge fund strategy by over 2.8 percentage points in annualized return.

If your market outlook is bullish, you will need a specific reason to expect a hedge fund to beat the index. Conversely, if your outlook is bearish, hedge funds should be an attractive asset class compared to buy-and-hold or long-only mutual funds.

Looking at the period up to June 2023, we can see that the Credit Suisse Hedge Fund Index lags behind the S&P 500 with a net average annual performance of 7.02% versus 9.83% for the S&P 500 (since January 1994).

Diversification Benefits

Many institutions invest in hedge funds for diversification benefits. If you have a portfolio of investments, adding uncorrelated (and positive-returning) assets will reduce total portfolio risk. Hedge funds—because they employ derivatives, short sales, or non-equity investments—tend to be uncorrelated with broad stock market indexes. But again, correlation varies by strategy. Historical correlation data (e.g. over the 1990s) remains somewhat consistent, and here is a reasonable hierarchy:

Fat Tails Are the Problem

Hedge fund investors are exposed to multiple risks, and each strategy has its own unique risks. For example, long/short funds are exposed to the short squeeze.

The traditional measure of risk is volatility or the annualized standard deviation of returns. Surprisingly, most academic studies demonstrate that hedge funds, on average, are less volatile than the market. For example, over the period from January 1994 to June 2023, volatility (annualized standard deviation) of the S&P 500 was about 15.16% while the volatility of the aggregated hedge funds was only about 6.63%.

The problem is that hedge fund returns do not follow the symmetrical return paths implied by traditional volatility. Instead, hedge fund returns tend to be skewed. Specifically, they tend to be negatively skewed, which means they bear the dreaded "fat tails," which are mostly characterized by positive returns but a few cases of extreme losses.

For this reason, measures of downside risk can be more useful than volatility or Sharpe ratio. Downside risk measures, such as value at risk (VaR), focus only on the left side of the return distribution curve where losses occur. They answer questions such as, "What are the odds that I lose 15% of the principal in one year?"

Funds of Hedge Funds

Because investing in a single hedge fund requires time-consuming due diligence and concentrates risk, funds of hedge funds have become popular. These are pooled funds that allocate their capital among several hedge funds, usually in the neighborhood of 15 to 25 different hedge funds.

Unlike the underlying hedge funds, these vehicles are often registered with the SEC and promoted to individual investors. Sometimes called a "retail" fund of funds, the net worth and income tests may also be lower than usual.

The advantages of funds of hedge funds include automatic diversification, monitoring efficiency, and selection expertise. Because these funds are invested in a minimum of around eight funds, the failure or underperformance of one hedge fund will not ruin the whole. As the funds of funds are supposed to monitor and conduct due diligence on their holdings, their investors should, in theory, be exposed only to reputable hedge funds.

Finally, these funds of hedge funds are often good at sourcing talented or undiscovered managers who may be "under the radar" of the broader investment community. In fact, the business model of the fund of funds hinges on identifying talented managers and pruning the portfolio of underperforming managers.

The biggest disadvantage is cost because these funds create a double-fee structure. Typically, you pay a management fee (and maybe even a performance fee) to the fund manager in addition to fees normally paid to the underlying hedge funds. Arrangements vary, but you might pay a 1% management fee to both the fund of funds and the underlying hedge funds.

In regards to performance fees, the underlying hedge funds may charge 20% of their profits, and it is not unusual for the fund of funds to charge an additional 10%. Under this typical arrangement, you would pay 2% annually plus 30% of the gains. This makes cost a serious issue, even though the 2% management fee by itself is only about 1.5% higher than the average small-cap mutual fund.

Another important and underestimated risk is the potential for over-diversification. A fund of hedge funds needs to coordinate its holdings or it will not add value: If it is not careful, it may inadvertently collect a group of hedge funds that duplicates its various holdings or—even worse—it could become a representative sample of the entire market.

Too many single hedge fund holdings (with the aim of diversification) are likely to erode the benefits of active management while incurring the double-fee structure in the meantime. Various studies have been conducted, but the "sweet spot" seems to be around eight to 15 hedge funds.

Questions to Ask

At this point, you are no doubt aware that there are important questions to ask before investing in a hedge fund or a fund of hedge funds. Look before you leap and make sure you do your research.

Here is a list of questions to consider when seeking a hedge fund investment:

• Who are the founders and the principals? What are their backgrounds and credentials? How long before the founders/principals expect to retire?
• How long has the fund been in business? What is the ownership structure? (E.g., is it a limited liability company? Who are the managing members? Are classes of shares issued?)
• What is the fee structure and how are principals/employees compensated?
• What is the basic investment strategy (must be more specific than proprietary)?
• How often is a valuation performed and how often are reports produced for investors (or limited partners)?
• What are the liquidity provisions? (E.g., what is the lock-out period?)
• How does the fund measure and assess risk (e.g., VaR)? What is the track record in regard to risk?
• Who are the references?

The Bottom Line

For most ordinary investors, hedge funds are out of reach as they cater to high-net-worth individuals (accredited investors) who can muster the often six- or even seven-figure initial investment minimums. Still, understanding a hedge fund's potential for outsized returns must be weighed against its unique risks and higher fees.