What are hedge funds, and why are they so revered by some and hated by others? Hedge funds are simply pools of money from specific investors designed to outperform the market through alternative investment strategies.
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Hedge funds involve higher risk, and thus participation is limited to accredited investors who have a net worth of over $1 million, a minimum income level, and some investing experience and knowledge. That gives hedge funds the deserved reputation as being a vehicle for the rich, part of the reason they elicit strong feelings one way or the other.
The higher risk comes via using active strategies to maximize the return. Use of futures, short positions, leveraged purchases, derivatives, and alternative securities allow hedge funds to multiply gains — or losses. Active management and correct forecasting are crucial to stay ahead. Hedge fund managers charge higher fees, typically two and twenty (2% of assets in management fees and 20% of profits), in return for more active management and correct insight.
However, hedge funds as a group have performed poorly in recent times. According to The Economist, the average hedge fund returned 3.3% in 2014 while the S&P 500 increased by 11.4%. A new paper by Mikhail Tupitsyn and Paul Lajbcygier of Monash University in Australia may explain why hedge funds are underperforming.
The paper charges that the majority of hedge funds are actually passive in their behavior, yet found that the more passive funds tended to outperform the active ones — and neither one performed as well as more market-neutral funds. In essence, most hedge fund managers cannot beat the market, especially in periods of prolonged growth. They just are not as good at correctly identifying the proper high-risk opportunities.
Over the study period from 1994-2010, hedge funds deemed as passive had average returns 0.1% lower than neutral funds, while active hedge funds had 0.28% lower average returns. Poorer performance with higher risk and volatility is a bad combination.
The time horizon is an important parameter in the analysis. According to the paper, in the short term, hedge funds tend to engage in "dynamic trading strategies involving complex securities," but over the long run, they develop passive behaviors. Given these returns, it is understandable how hedge funds can naturally drift toward passive behavior. Only the most skilled of active managers can consistently produce in the high-risk sector, and those with less skill and/or luck are forced to accept a more passive strategy to survive.
Statistics on hedge fund performance back up this claim. The paper finds that only 15%-20% of funds that start active stay active through periods of poor performance. Meanwhile, 70%-85% of funds with a more passive strategy in the beginning stay with that strategy.
While active and passive are subjective terms, the paper uses a thorough statistical analysis to classify the funds according to what the authors call linear and non-linear risk exposures. Linear risk exposure contains proportionate risk according to reward, while non-linear risk exposure amplifies the effect, whether gains or losses. Leverage is a good example of non-linear behavior, where buying with borrowed money amplifies the return (you can invest more money than you actually have) and the risk (you can lose more money than you actually have).
Hedge funds tended to fall into distinct types. Arbitrage, managed futures, and event-driven strategies were primarily non-linear and active, and emerging markets, long-short equity, and dedicated short bias funds were more linear and passive.
The bottom line: just because a fund is called a hedge fund does not mean that it consistently takes the active, high-risk high-reward approach. Make sure that the higher fees you are paying for active hedge fund management are actually going toward active management and that the management is producing significantly higher returns over the long run. If not, why would you bother with a hedge fund at all?