What is a Hedge Fund? (Part II)

You can trust that we maintain strict editorial integrity in our writing and assessments; however, we receive compensation when you click on links to products from our partners and get approved. Here's how we make money.

By Jeff Stoffer, CFA, CFP

Learn more about Jeff on NerdWallet’s Ask an Advisor

According to Webster, the word “hedge,” as it relates to investments, originally meant “a means of protection or defense (as against financial loss.)” Hedge funds can be used to diversify a portfolio and reduce risk by providing investments that do not move in the same direction at the same time. If your portfolio consists entirely of U.S. stocks, you might choose to invest in something else that cushions the blow when stocks decline – an alternative investment that would appreciate when stocks decline.

In this way, you’ve lowered the risk of your portfolio; you can think of hedging, then, as taking out insurance in case you are wrong. In investment lingo, hedge funds tend to have lower correlations with other investments such as stocks and bonds. In the example above, the hedge does not actually have low correlation, but negative correlation. It goes in the opposite direction of the stocks.

The number of hedge funds has increased dramatically, from 530 in 1990 to over 8,000 at the end of 2009[1]. Although not all of them operate in the fashion described above, their promised ability to make money in all types of markets is one of the perceived positive features that make them attractive to investors. Whether they can actually do this is another matter, which I will discuss in more detail.

Smart investors with decent track records at making money run these funds. This is a big reason people invest with them in the first place. Many, if not most, managers have a huge chunk of their personal fortunes invested in the funds they manage. This is good. Investing with the “smart money” sounds logical, but what happens now that we have thousands of hedge funds? Many of them pursue similar strategies and investments in their attempts to make money. Reminds me of the statistic that most of us think we are “above average” drivers . . .

So what are the downsides to investing in hedge funds?

I often describe a hedge fund as a “black box.” You put money in, something happens to it (you have no idea what) and hopefully decent returns come out. Hedge funds tend not to disclose a great deal about what they do or how they make money. Since they are not highly regulated, they aren’t required to provide much information. This is a big hurdle for me. If I don’t understand something, I’m suspicious and skeptical.

Another complication presented by hedge funds is “lock up” periods, or times when you are restricted from taking your money out. In addition, fees are considered high, often described as “one and twenty” or “two and twenty.” This means you pay one or two percent of assets being managed and then 20 percent of the profits generated. In a recent 15-year study[2] hedge funds in aggregate added value but the fees exceeded the value generated in investment returns.

Another major concern centers on assessing how well a hedge fund actually accomplishes objectives. Hedge funds are difficult to evaluate, even for professionals. A writer I respect, Doug Kass, says of hedge funds, “they take uncommon risks for common returns.” (His article, “Profiling the 2006 – 07 Bear Market,” appeared on thestreet.com, 08/07/06.) In other words, many hedge funds do not outperform other investments, or generate solid returns with lower risk. If you look at hedge fund performance during the most recent financial crisis, most did poorly. Not only did they not make money in a dismal market, many lost money – in some cases a lot!

That is not to say there aren’t great hedge fund managers out there who can add value to your portfolio. But I suggest they are few in number and difficult to evaluate. Like finding gold, is the success of a hedge fund the result of skill or luck? Some managers are truly skillful, but how can we establish that? When it comes to investment returns, what was bestowed by good luck can just as easily be taken away by bad luck!

Therefore, let the buyer beware.

[1] Hedge Fund Research. (20 Jan. 2010). Investors Return to Hedge Fund Industry as New Model [press release]. Retrieved from Roger G. Ibbotson, Peng Chen, CFA, and Kevin X. Zhu. “The ABC’s of Hedge Funds: Alpha, Beta and Costs.” Financial Analysts Journal, CFA Institute, vol. 67 Number 1, Jan./Feb. 2011: 15-25.

[2] Roger G. Ibbotson, Peng Chen, CFA, and Kevin X. Zhu. “The ABC’s of Hedge Funds: Alpha, Beta and Costs.” Financial Analysts Journal, CFA Institute, vol. 67 Number 1, Jan./Feb. 2011: 15-25.