Investors are often misguided by misconceptions about hedge funds in the market. Among them, the most common revolve around the risks, ethics and performance associated with hedge funds. It is necessary to clear up these misconceptions as hedge funds form a sizable part of the investments industry in many developed countries and are worthwhile investments if understood correctly.
Misconception 1: Hedge funds are more risky than traditional investments
Reality: On average, hedge funds are, in fact, less risky than traditional long-only investment funds. A comparison between the 3-year, 5-year, and 10-year volatility of hedge fund returns against traditional asset classes shows that hedge funds are consistently less volatile. On average most hedge funds are positioned defensively, which leads to outperformance in a bear market and underperformance in a market upcycle.
Below we compare the volatility of a hedge fund index, the S&P500, and the DIA:
Misconception 2: Hedge funds are unregulated and secretive
Reality: Hedge funds are largely secretive about their investment strategies as it is part of their intellectual property and is the basis of their returns. Like all investments, hedge funds operate in a highly regulated environment. Hedge fund regulations have tightened significantly since the 2008 Financial Crisis, with the current best practice being monthly distributions and reporting. While the lack of complete transparency may put off some investors, it is this slight opaqueness that protects the competitive advantage of hedge funds and allows them to generate returns.
Misconception 3: Overall returns are worse than investing in traditional investments
Reality: This is probably true, which is why certain active management strategies like equity long short are going out of business as investors comes to believe that even professional managers cannot beat passive market returns over the long run. However, sophisticated institutional investors judge hedge funds not only by their returns, but also by other critical metrics like correlation to the broader market, risk-adjusted return ratios, skewness and kurtosis, VaR and others. Some investors see quant funds as heralding the inevitable disruption of machine learning in financial markets, which is why they have to allocate or miss out. In general, it is important for large money managers to diversify their portfolio enough to weather market cycles and most will try to remove market risk altogether in search of absolute returns. Hedge funds exhibit lower correlation to traditional asset classes, providing downside protection when it is needed the most and hence fare better during market drawdowns.
This chart shows hedge fund vs S&P500 index monthly returns in 2018 and 2019:
Misconception 4: Investors have to give up liquidity and access to capital when investing in hedge funds
Reality: Hedge fund liquidity profiles can range from daily liquidity, to monthly, quarterly or annual liquidity. The liquidity profile of a hedge fund determines the opportunity set a hedge fund manager is able to tackle, hence, investors seeking daily liquidity cannot expect the same results as that of a hedge fund with annual liquidity. If liquidity profile is an important criteria for the investor, they may still go for the daily liquidity option in the hedge fund space, but must be willing to give up on the less liquid, higher growth potential opportunities which hedge funds typically invest in.
Misconception 5: Hedge funds use exotic assets and investment strategies
Reality: Hedge funds invest in the same securities available to any investor but have a wider range of options available to optimise these assets, including derivatives, short-selling, and leveraging. More recently, hedge funds have increasingly incorporated technology to support them in achieving market-beating risk-adjusted returns. This give hedge funds a greater ability to protect capital while seeking absolute and uncorrelated returns.
Investors tend to shy away from investing in hedge funds, as they are misconstrued as risky, illiquid investments which produce unfavourable returns when compared to traditional assets. The truth is that hedge funds have characteristics which differ from traditional or passive investments. Hence, investors should not look to hedge funds as a substitute for a portfolio of traditional assets but instead as an addition to a diversified portfolio due to their unique risk/return characteristics. Hedge funds complement traditional portfolios by providing the potential of better returns with reduced portfolio volatility.