The regulator has created a separate class of funds to house hedge funds, which implies that these funds are constructed from radioactive materials that require special handling by investors. Similarly, advisors often use their fee structures to dissuade investors from using them.
This article critically reviews both these perspectives and concludes that, while hedge funds are complicated investments that require more attention, investors may be handicapping themselves by not accessing the most sophisticated investment technology currently available to them.
The case for hedge funds
Hedge funds play an important role in the operation of financial markets. By taking speculative positions they can provide liquidity, which allows all other investors to invest more cheaply. In addition, since hedge fund returns are usually uncorrelated to those in the equity and bond markets, they can provide significant diversification benefits to investors’ portfolios.
Why have regulators put hedge funds into a different (regulatory) box?
There are three reasons for regulating any investment vehicle: firstly, to protect consumers; secondly, to protect the smooth operation of financial markets; and, finally, to protect the stability of the financial system. These are compelling reasons but the creation of a separate class for hedge funds suggests that they are somehow different to, and riskier than, other types of investments. Is this perception justified?
Hedge funds can do several things which traditional investment vehicles cannot. Firstly, they can, and often do, go short. This allows hedge funds to provide positive returns for their investors when asset prices are going down, not only when they are going up. This is a significant advantage over traditional funds. It is also riskier given that most asset markets have a positive trend.
Hedge funds can do several things which traditional investment vehicles cannot.
The second difference is that hedge funds can use leverage to expose the fund to more risk (and return) than the initial capital invested. This again creates space for better fund performance, but also more risk to be managed. Finally, hedge funds can take naked derivative positions. While being more flexible and allowing for leverage using derivatives, this also adds to the risk level as these can backfire if not done appropriately.
These three additional sources of investment flexibility give hedge funds the ability to deliver different patterns of returns, but they also create a bigger opportunity set for getting them wrong. This suggests that they are indeed in a different category from a fund management perspective. This also means that risk management is the foundation for any successful hedge fund manager.
The implication is that investors must be able to assess and trust in their manager’s risk management processes. It certainly does not, however, mean that all hedge funds will blow up.
Are hedge funds expensive?
Hedge funds are commonly deemed to be expensive. This is because of the historical practice of charging a “2 and 20” fee structure (a 2% fixed management fee and 20% performance fee). This has changed somewhat: according to Novare’s 2019 hedge fund survey the most common management fee is now 1% while performance fees are still set around 20% in the main. By comparison, the February 2021 Corion Report indicates that, for the top five balanced funds, the average management fee was 1.05% and two of these had performance fees of 10%.
This suggests that while hedge funds do continue to have relatively more aggressive performance fee levels, their base fees are remarkably like traditional funds. It also indicated that understanding the basis for the performance fee calculation is especially important for investors considering the use or performance of hedge funds.
Should investors use hedge funds?
The answer is hedge funds should be part of any investor’s consideration set. It is important to note that they are more complex investment vehicles, which means that their separate regulatory classification is appropriate and that they need to be assessed differently to traditional funds. However, they add value to the financial system, and it is exactly this complexity that gives them a potential place in investors’ portfolios.
Finally, while their performance fees may be higher, their management fees are not expensive. Performance fees are only paid when the hurdle rate is achieved – so the client is only paying for performance when it is earned.
In summary then, regulators are right to flag the additional inherent complexity of hedge funds. Investors are losing out, however, if they dismiss them because they are “too risky” and “too expensive”. They offer something different and it is this difference that both makes them attractive and requires more attention from investors.
