Hedge funds have become increasingly popular in the last one or two decades, as investors have discovered the benefits of adding them to their portfolios. This article explains the most significant ones – diversification potential, higher returns and access to new investment opportunities.
Diversification potential is widely accepted as the greatest benefit of hedge funds (and alternative investments in general). By adding hedge funds to a typical portfolio of stock and bond investments you can achieve higher risk-adjusted return (higher return and/or lower volatility, other things being equal).
The reason is that most (although not all) hedge fund strategies have consistently shown low correlations to the performance of global stock and bond markets. In other words, hedge funds often make profits even when stock prices are falling and traditional investments are losing money.
Strategies which tend to perform particularly well during periods of high volatility and decreasing stock prices include short selling, global macro and managed futures. On the contrary, the performance of strategies with net long market exposure, such as long/short equity or distressed securities, tends to be more highly correlated to market returns.
Higher returns and alpha
Investment theory differentiates between two components of returns – alpha and beta.
Beta results from systematic exposure to the market. For example, when you buy an index fund which tracks the S&P500 index, such as the SPY ETF, it is highly likely that your return will be the same as the performance of that index. Your entire return will come from beta. The downside is that you will only make money when the stock market as a whole goes up.
On the other hand, if you invest with a skilled manager who is able to pick stocks which outperform the market, your return will be higher than the overall market’s performance. The difference is alpha – the part of return which comes from skill, rather than from taking systematic risk.
Naturally, alpha is very highly valued in the investment world, because very few people (including professional fund managers) are able to consistently outperform the market and generate positive alpha in the long run. Many of these highly skilled managers work for hedge funds and therefore hedge funds are known for being able to generate alpha.
This does not mean that all hedge funds always perform better than traditional funds. While most people hear about hedge funds when media report stories about star managers who have just made 100% or more in a single year, it is extremely rare for a fund or a manager to deliver such performance year after year. Many hedge funds can consistently beat the market, but triple digit returns are outliers.
In general, some hedge fund styles, such as global macro, have (as a group) shown higher long term returns than others, such as short selling. However, even greater differences exist among individual funds within each style group.
Besides higher returns and diversification potential, hedge funds also represent a possibility to invest in assets and trading strategies which would be inaccessible with traditional funds. Examples include highly illiquid securities or derivatives. This is due to the fact that, compared to mutual funds, hedge funds are more loosely regulated and their managers enjoy greater freedom in terms of what and how they can trade.
When investing in hedge funds, you should also be aware of their limitations, disadvantages and risks, which often arise from the same factors as the above listed advantages – greater freedom in trading strategies, access to illiquid or exotic assets and greater importance of the fund manager’s skill (which the manager wants to be handsomely compensated for).
We take a look at the disadvantages of investing in hedge funds in our next post.