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Hedge Funds Investment Considerations
Author: Joel Baretto, CFP®
March 14, 2025
A hedge fund is a pooled investment fund that employs various strategies to generate returns for its investors. It typically targets higher returns than traditional investments like mutual funds, using techniques such as short selling, leverage, derivatives, and arbitrage. Hedge funds often invest in a wide range of assets including stocks, bonds, commodities, and real estate.
What sets hedge funds apart is their flexible investment strategy, the use of more sophisticated financial instruments, and their generally higher risk profile. They tend to have very high minimum investment amounts and usually open only to accredited investors (those with a high net worth or institutional investors), and they charge performance-based fees, often around 20% of the profits, in addition to a management fee. This makes it difficult for retail investors to access unless they go through an institutional wealth manager who may also charge a fee for assets under management (AUM).
Hedge funds can vary significantly in their performance compared to the broader markets, depending on the strategies they employ, their risk tolerance, and the skill of their managers. However, some general trends and data can help shed light on the comparison:
1. Historical Performance
- Hedge Funds vs. S&P 500: Historically, hedge funds have not always outperformed the S&P 500, especially after fees. According to studies, hedge funds have delivered annualized returns that are often close to or slightly higher than the broader market, but after management and performance fees (which can range from 1-2% of assets plus 20% of profits), their net returns often fall short.
- Return Comparison: The S&P 500 has averaged around 7-10% annualized returns over long periods. Hedge funds, on the other hand, tend to have more variable returns, sometimes beating the market in certain years, but often falling behind over the long run.
2. Risk and Volatility
- Risk-Adjusted Returns: Hedge funds typically aim to generate positive returns regardless of market conditions. Many hedge funds use strategies like short-selling, derivatives, or leveraging, which can reduce risk or enhance returns during downturns. However, this means they can be less volatile than the broader market, especially during market crashes.
- Sharpe Ratio: Hedge funds often aim for a better risk-adjusted return, meaning they try to deliver stable, consistent performance with lower volatility. In some cases, this has led to a better Sharpe ratio (a measure of risk-adjusted return) than the broader market.
3. Types of Hedge Funds
- Equity Hedge Funds: These are designed to outperform the stock market, but they don’t always do so. They might have concentrated positions in stocks they believe will outperform, or use hedging techniques to mitigate market risks.
- Global Macro: These hedge funds invest based on macroeconomic trends (like currency movements or interest rates) and may not directly correlate with equity markets. Their performance can vary greatly depending on the accuracy of their economic predictions.
- Event-Driven: These focus on mergers, acquisitions, or corporate restructuring. Their performance depends on how well they can predict corporate events.
4. Market Conditions
- During strong bull markets, hedge funds might underperform because they tend to be more cautious, holding hedges or using defensive strategies. In bear markets, however, their ability to short-sell or hedge against market declines may allow them to perform better.
5. Recent Trends
- Over the last decade, many hedge funds have struggled to beat the market, especially since the bull market following the 2008 financial crisis. Passive investing (like index funds) has become increasingly popular, which has made it harder for hedge funds to consistently outperform the market, especially after fees.
Conclusion
Hedge funds are alternative investments that may have low correlation to the broader traditional market, thereby providing an opportunity for diversification within a portfolio. Accessing hedge funds may be a lot more challenging for retail investors who are not considered sophisticated or high-net-worth accredited investors. While hedge funds often tout their ability to deliver absolute returns regardless of market conditions, their performance has been mixed compared to traditional markets. They might outperform in certain market environments, but in general, they have not consistently beaten the S&P 500 after considering fees and expenses. Investors looking for higher returns might choose hedge funds for diversification or to hedge against risk, but they are unlikely to always outperform broader equity indices in the long term.
Alternative investments provide a good mix to a diversified portfolio but require professional guidance. Talk to a qualified wealth manager to help you determine a suitable portfolio based on your objectives and situation.
Disclaimer:
- The information provided is for educational purposes only and does not constitute personal financial, tax or investment advice and should not be relied on as such. It does not take into consideration any investor’s particular investment objectives, strategies, time horizon, and tax or legal status. Abacus Wealth International (AWI) does not provide tax or legal advice. Please consult a tax or legal professional for corresponding tax and legal advice.
- All material and content have been obtained from sources believed to be reliable. AWI does not guarantee the accuracy of the information provided and shall not be held liable for decisions based on the foregoing information.
- All examples of graphs, financial products and historical returns contained in the foregoing material are for illustration and educational purposes only and shall not be deemed as financial advice or recommendation. Past performance is not indicative of any future investment returns.