It’s easy to hate hedge funds and their managers. They are simultaneously glorified and vilified by their outsized compensation or less than popular investment tactics. However, one thing to note is that much of this anti-hedge fund sentiment has been popularized by mass media outlets blaming them as a major cause of economic inequality. Despite these negative views, what we find is that hedge funds are generally unappreciated and not given enough credit for what they are intended to do.
Before discussing why hedge funds are underrated, it’s important to truly understand the definition of a hedge fund. Hedge funds, as their name suggests, are intended to better control certain aspects of risks while still generating profits. This does not necessarily mean more absolute profits or huge returns. The expectation here is that a good hedge fund manager will be able to deliver a range of returns within a certain acceptable band of risk. Now that we have a solid understanding of what hedge funds are expected to deliver, let’s take a look at why they should still be considered strong candidates for portfolio inclusion.
1. The True Purpose
2014 was considered a critical year in which investors scrutinized hedge funds, most notably the fact that there was only a very small percentage of hedge funds that outperformed the S&P 500. However, while not applicable to all strategies, many hedge funds build in protections against downside that can become a drag on upside performance. Many investors mistakenly believe that hedge funds automatically provide carte blanche to outperform the market. Instead, hedge funds are best considered ways to achieve capital preservation, reduced volatility, more diversification, and of course risk-adjusted returns.
2. Top Returns Speak for Themselves
It’s easy to vilify an industry with a few folks generating billions in personal compensation. However, at the end of the day, a large amount of private and institutional wealth are still investing in hedge funds. Obviously, there are different risk-return paradigms and liquidity needs, but the amount of capital that does generate returns speaks for itself. For instance, all funds included in Barron’s list of top 100 hedge funds have managed to achieve three-year annualized gains of at least 15%, with the very best funds achieving between 40 and 50%.
3. Hedge Funds Have Institutional Advantages
While we all would like to believe that there are perfect market dynamics at work, the truth is that large players such as hedge funds with additional infrastructure and capital are better equipped than individual investors to make timely and profit-maximizing moves. This inherently creates enhanced opportunities for hedge funds to create diversified and risk-adjusted returns in the marketplace. The best managers that have their investors’ interests as their core motivation do very well and command a loyal investor following. Depending on the investor’s expertise and risk profile, it may be better to allocate time and research into analyzing money managers as opposed to searching for standalone opportunities that will require significant resources and ongoing maintenance.
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