Hedge Funds: Portfolio Friend or Foe?

By Julie Neitzel

Hedge funds are designed to outperform the public markets. Unfortunately, there is strong evidence that the hedge fund hype may exceed the reality of their investment performance. The compound annual return from 2005 through 2014 was only 0.7 percent (well below every major asset class, including treasuries). For example, 2015 saw the closing of several large, well-known hedge funds: Fortress’ flagship fund (was $8 billion in 2007, down to $1.6 billion in late 2015) and Bain Capital’s Absolute Return Capital hedge fund (double-digit losses last year).

Performance was disappointing in 2015 as the HFRX global hedge index delivered a disappointing negative 3.6 percent return, while renowned funds such as Pershing Square and Greenlight Capital suffered large losses (approximately 20 percent) for the year. During 2015, hedge funds attracted a net $44 billion, the smallest amount since 2012, according to Hedge Fund Research Inc. Even with the weak performance history, over $3 trillion of hedge fund assets exist.

Research on hedge fund mortality references that 30 percent of new funds don’t make it past 36 months due to poor performance; 50 percent of all hedge funds never reach their five-year anniversary; and only 40 percent survive for seven years or longer.

According to Bloomberg, the 20 most profitable hedge funds account for 48 percent of the $835 billion in profits that the hedge fund industry has generated since its inception. Over the last 10 years, the top 20 managers collectively made $308 billion, even through the challenging 2008 market. The conundrum is that there are approximately 10,000 hedge fund.

Most top-performing funds have a high minimum, which limits individual investor access unless a $10 million investment can be made. Other hedge fund managers may offer their strategies through the private bank and brokerage platforms with minimum investments generally around $1 million.

Many times, fund manager fees are shared with the distribution platform (to gather assets), so the incentive to encourage client investment may not be correlated to a fund’s investment returns. Recently, liquid alternative mutual funds (also called 1940 act funds) have been made available to retail investors with very low minimums.

Hedge fund drawbacks include high fees (generally 1.5 to
2 percent annual management fees, plus profit participation), limited liquidity, general tax inefficiency due to higher trading levels, and a lack of full transparency on the fund investments. Institutional investors hire consultants to evaluate and identify appropriate hedge fund managers while high net worth individual investors generally rely on recommendations from their private bankers, which may be incentivized to sell hedge funds based on firm and individual compensation and not necessarily investment merit.

There’s an abundance of strategies, including long/short, global macro, event-driven, merger arbitrage, private credit and fund-of-funds. The performance difference between a good and bad manager is considerable.

There can be benefits to including hedge fund strategies within a portfolio. The lack of transparency can allow a skillful manager to exploit market dislocations or volatility discreetly. Fewer liquid investment vehicle structures allow managers to focus on managing investments rather than potential daily redemptions. Longer lockups of invested capital and fewer redemptions can contribute positively to investment performance. The high fees associated with hedge funds enable managers to attract high-caliber talent and align compensation with investor interests.

It is important to analyze the bottom line when considering whether hedge funds are the right fit for a portfolio. In 2008, Warren Buffett made a bet with a prominent hedge fund manager that a low-cost S&P 500 Index fund would outperform high-fee hedge funds over a 10-year period. With just two years to go with this bet, Buffett’s investment is up over 65 percent while the hedge funds have gained only 22 percent.

A carefully chosen portfolio of hedge funds can generate more attractive risk-adjusted returns, however, the challenge herein lies in identifying those hedge fund managers that can, in fact, add value. ¿

Julie Neitzel is a partner and advisor with WE Family Offices in Miami and a board member of the Miami Finance Forum. Contact her at julie.neitzel@wefamilyoffices.com or 305.825.2225.

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