Are Hedge Funds Really That Evil? Challenging The Common Hedge Fund Myths

by: Kamile Gimbutaite

Summary

Investors are often misguided by myths and misconceptions about hedge funds prevalent in the market.

Among the most common myths are that hedge funds are risky, expensive, fraudulent, inaccessible and generally bad for society.

Myths are busted by evaluating information realistically, objectively and avoiding generalisations.

myths

I will not surprise anyone by concluding that the coverage of hedge funds in the media and the general public opinion about them is negative, including some regulators and representatives of the Academia. This is counter intuitive, because, as I explained before, properly selected hedge funds demonstrate great results and have the potential to improve any investment portfolio. But what we see in the headlines most of the time is "average performance", "high fees", "flashy" lifestyles of hedge fund managers or fraud related "scandals". Indeed such topics generate more buzz than news about good performance, but part of the reason is that hedge funds are slightly mysterious and not fully understood, especially by individual investors, "grey area" in the investment field thus surrounded by many rooted myths. In this article I summarize, discuss and try to bust some of the most prevalent hedge fund myths and misconceptions.

MYTH NO. 1: Hedge funds are only accessible to institutional investors and (ultra) high net worth individuals - they are not available to retail investors like me and you.

REALITY: Due to structural innovations, e.g. liquid alternatives, UCITS funds, etc., hedge funds are lately as accessible to retail investors as ever since their minimum investment amount may be as low as USD10k or even USD1k. Moreover, some hedge funds are traded on exchanges (e.g. London Stock Exchange Hedge fund list or Eurekahedge UCITS database), while funds of hedge funds may pool private investors' money together and invest into hedge funds otherwise harder to access. Finally, there is a wave of fin-tech startups engaging in various ways to replicate hedge fund strategies or pool investors' capital that are entering the scene (e.g. Sliced).

On the other hand, hedge funds are complex structures requiring knowledge and experience to comprehend, thus it is naive to expect and strive to have every mom and dad be able to invest with them. Besides, hedge funds are dedicated for long term investment and create the most value over long investment horizons, thus higher minimum investment amount makes sure to filter those who can afford themselves quarterly or even annual liquidity, i.e. are less likely to experience sudden liquidity needs.

MYTH NO. 2: Hedge funds are very risky.

REALITY: All investment tools, vehicles and strategies bare both general and their own unique risks. Most of hedge funds' structure and operational risks are addressed via proper due diligence process, while if we define riskiness by the standard deviation of performance, hedge funds as a group are less volatile than such traditional assets as stocks.

volatility

So it means that owning stocks has significantly more downside risk than owning hedge funds, because the latter are more flexible, active and have a wider toolkit of strategies at hand, including shorting. Moreover, since hedge funds exhibit low correlation to most traditional asset classes (see below), once added to an investment portfolio, they are able to reduce the volatility of the overall investment portfolio.

correlations

Source: Natixis

MYTH NO. 3: Investing with hedge funds, investors have to give up liquidity and access to their capital.

REALITY: Liquidity profiles of hedge funds can range from daily liquidity (e.g. liquid alternatives), to very common monthly liquidity, to quarterly or annual, so if liquidity is the main criteria of an investor, (s)he definitely has a range of options. However, firstly, liquidity profile determines and affects directly the opportunity set the manager is able to tackle, so it is difficult to expect a daily liquidity fund post the same results as annual liquidity vehicle, and secondly, if your main criteria is liquidity, hedge funds might not be the place for you at all. To conclude, yes you can access highly liquid options in hedge fund space, but then you might need to give up some of the less liquid (but naturally higher potential) opportunities that hedge funds are only able to tackle due to their structure in the first place.

MYTH NO. 4: Hedge funds are too expensive.

REALITY: It depends very much who you are comparing to. Yes, hedge fund fees are higher in absolute terms than e.g. mutual fund fees. However, this is the price not only for the access to different, complex, unique, niche tools and strategies hedge funds provide, but also the risk management infrastructure in place to handle difficult situations in the markets better than yourself or a long only mutual fund manager would. Moreover, hedge fund fee structure serves in aligning the interests of investors and managers which are both interested in better results, while you can't really call mutual fund fees "motivating". Finally, hedge funds' results we see are already after-fee results and they obviously satisfy investors and justify the fees since industry assets are at all-time highs and large part of the hedge fund inflows come from very sophisticated institutional investors.

MYTH NO. 5: Hedge funds don't help in a market crash.

REALITY: As demonstrated earlier, hedge funds exhibit lower correlation to traditional asset classes, providing the real diversification (and downside protection) exactly when it is needed the most - during crises and market crashes. As seen in the picture below, hedge funds proved to fare better than stocks during each of the recent market downturns.

crises

Hedge funds: HFRI Fund Weighted Composite Index. World stocks: MSCI World Net Total Return hedged to USD

Source: Bloomberg, MSCI, Man Group

MYTH NO. 6: The most important thing in hedge fund selection is a large house and a respected name.

REALITY: While many investors see these attributes as an assurance of quality and investor trust, they are no way a substitute for proper due diligence on a fund. The same way as large and well-known banks appear to engage in rate fixing scandals, there are plenty examples of "large houses" and "respected names" among hedge funds that have conducted fraud, abused investor rights and/or blew up, the classic ones being the Galleon Group, SAC Capital, Madoff Investment Securities.

It is true that large investment houses provide an exceptionally high level operational infrastructure, but these days even a 100-million fund is able to access most of those solutions. Moreover, due to being nimble, innovative and diligent, smaller and newer funds reportedly outperform many of the large renowned peers.

To conclude, large house and a respected name should not be a hedge fund selection criteria: neither it protects from fraud, nor guarantees superior performance. However, hedge fund due diligence and selection requires specific expertise and experience-based judgment so it is advisable to consult specialists anyway.

MYTH NO. 7: Hedge fund managers are dishonest, unscrupulous fraudsters.

REALITY: This is exactly the public opinion formed by the media which tends to catch and escalate the juicy stories of exuberant lifestyles and securities fraud. However, those stories are relatively few compared to almost 15 thousand hedge funds existing out there so there are as many cheaters in the hedge fund industry as there are in oil and gas, pharmaceuticals, politics and anywhere else. The majority of the hedge fund managers are very talented investment professionals with a unique idea or skillset trying to exploit it and make a living by earning investors return and their capital. It is investors' concern to ascertain who are they trusting their money with.

MYTH NO. 8: Hedge funds are unregulated "blackboxes".

REALITY: In the aftermath of the recent financial crisis, hedge funds became as regulated as ever with such impactful regulations as AIFMD, UCITS, MIFID, Dodd-Frank etc. introduced in order to maintain the perceived stability of financial sector. It depends on certain jurisdictions, but generally the times of two dudes with a laptop at a garage are gone - it takes time, money and expertise to get and maintain all the operational, compliance, reputation checks from the regulators while investor expectations and standards, especially if you target institutional investors, has also brought operational and governance practices to a new level.

When it comes to transparency, the industry standard has gone further away from opaque reporting and the current best practice is monthly distribution including, depending on a strategy, a certain level of portfolio transparency allowing for a picture of strategy implementation. On the other hand, a complete or regulated transparency would take away hedge funds' competitive advantage that allows them to generate returns in the first place.

MYTH NO. 9: Hedge funds are evil and does bad to the society

REALITY: Besides helping people and institutions achieve their financial goals, hedge funds serve to the financial industry and society in general. They are sometimes the last resort buyers of assets no one else wants to buy providing liquidity to the markets. They often provide capital to innovative projects as well as small and medium size businesses that face difficulties raising capital from more traditional sources. Hedge funds employ very talented and professional people for highly paid roles, who in turn pay large amount of taxes. Hedge funds not only donate significant amounts to non-profits and charities, but also when included in investment portfolios of foundations and endowments help earn money to support communities, improve education, health, economic areas, foster cultural development. Included in investment portfolios of endowments, hedge funds help them fund scholarships while included in investment portfolios of pension plans hedge funds allow them provide retirement security to millions of people. In fact, most of the money recently flowing into the hedge fund industry is exactly the institutional money.

Due to some or all of the mentioned myths rooted around hedge funds, some investors miss the opportunity to access unique ideas, niche strategies and innovative tools and achieve the portfolio enhancement hedge funds provide. While the negative views on hedge funds and the whole financial industry may continue attracting the media attention, what is important for an investor is to evaluate critically, realistically and objectively the information, avoid generalization and trust their own or their advisors' competence in finding the best solutions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: MC Investments is a hedge fund due diligence and manager selection advisory.