There are several compelling reasons why investors should avoid hedge funds. Their fees are high, with most charging 2% of assets under management (AUM) and 20% on any profits. These funds can also be illiquid, with lock-up periods averaging about one year. Since 2009, their investment performance has been inconsistent and lackluster at best. However, none of that appears to be deterring ultra-high-net-worth investors and institutions, which continue to pour money into hedge funds with assets totaling nearly $3 trillion. This activity raises the question as to whether hedge funds are worth it, considering they haven’t outperformed a 60/40 allocation of stocks and bonds since 2002.

Why Hedge Funds Underperform

While it is true that hedge funds have underperformed equity investments for more than a decade, it is important to understand why. First, the number of hedge funds has grown from a few hundred in 2008 to more than 10,000 in 2016. This figure suggests that a lot of hedge fund managers are trying to chase relatively few opportunities to add alpha to their portfolios. Secondly, asset growth has been dominated by institutions, which tend to prefer portfolio stability and downside protection over outsized returns, and fund managers are happy to oblige. Finally, hedge funds are not designed to outperform equity funds in a raging bull market. Rather, they are designed to seek steady, risk-adjusted returns while minimizing losses in all types of markets.

Although there are some hedge funds that shoot for outsized returns, most utilize strategies that limit their upside because they are also trying to limit their downside. To achieve steady risk-adjusted returns, hedge funds must be able to outperform during down markets while capturing some part of the returns in up markets. That case could be made when comparing the negative 24% return of hedge funds during the stock market crash of 2007 through March 2009 with the 39% drop in the Standard & Poor’s 500 Index over the same period.

Hedge Funds Outperform in Volatile Markets

The last period when hedge funds outperformed the S&P 500 was during the lost decade from 2000 to 2009, when the stock market experienced extreme volatility and generally moved sideways. This environment is when hedge funds are at their best and earning their high fees. If the stock market action in the first couple of months of 2016 is any indication, hedge funds could begin earning their fees once again.

Certain hedge fund strategies are designed for the type of market environment present in early 2016. Funds using a long/short equity strategy hold both a long portfolio and a short portfolio, buying stocks they expect to outperform and selling short stocks they expect to underperform. A similar strategy is market neutral, which seeks returns totally independent of market performance while limiting volatility. Both strategies are considered low risk.

More Return Opportunities

For investors who want to add return opportunities to their portfolios in any market environment, many hedge funds utilize strategies targeting special situations. An event-driven fund might look for situations such as potential mergers, acquisitions or an earnings disappointment to capitalize on price inefficiencies that occur before and after the event. Merger arbitrage funds are event-driven funds that buy and short sell the stocks of two merging companies. Activist hedge funds look for opportunities with companies that are undervalued because of poor management or corporate structure. They buy large stakes in such companies and seek to influence management to make changes that may uncover shareholder value. The risk expectancy for all three strategies is moderate.

Tactical Diversification

Hedge funds are best utilized in the context of an overall investment plan, where they can increase diversification or enhance an asset allocation strategy. Hedge funds are managed to act as a non-correlating asset that can complement an equity portfolio. Portfolios that are heavy with equities could use short-biased or market neutral funds as a hedge, and portfolios weighted toward fixed-income investments may want to add a fixed-income arbitrage fund to counter rising interest rates. The key to matching the right type of hedge fund to an asset allocation strategy is understanding the fund’s objective and its return and risk aim.

The most challenging aspect of investing in hedge funds is choosing the right fund. With more than 10,000 funds with a highly diverse range of strategies, hedge fund investing requires extensive due diligence, which may be best conducted by a relevantly experienced financial advisor.

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