This question is something more investors should focus on. The short answer is,“yes.” The complete answer is longer, but important for investors to understand. While we can't cover everything here, at the end I’ve also included a few links to articles that can add further context.
The term hedge fund is often improperly used by both professional investors and the press. It might be best to think of a hedge fund as a portfolio management business structure versus an investment strategy.
Potential Hedge Fund Forms
Hedge funds can take almost any form the hedge fund manager deems is appropriate. They can represent any of the following strategies and more:
- Long-only stock funds focused on U.S. stocks, international stocks or both
- Fixed income / bond investments in the U.S., overseas or both
- Currency or interest rate investing in U.S. or foreign securities
- Long-biased long/short equity, fixed income or currency
- Short-biased long/short equity, fixed income or currency
- Short-only equity, fixed income or currency
- Equity, fixed income or currency arbitrage
- Quantitative computer-driven equity or fixed income trading strategies
- Deep or fundamental value
- Momentum growth
- Concentrated sectors or industries
- High yield bonds or distressed debt
- Restructuring or bankruptcy debt
- Real estate securities or debt
- Private equity or debt
- Private lending
Yes, this list is long, but it could easily be longer. Funds can be invested in just one of these approaches or have the flexibility to invest in many or all of them (these flexible approaches are sometimes called multi-strategy or global macro funds). A more complete listing with some general explanation can be found by reviewing the HFR classification list.
Related to this, I often see the press and investment professionals compare hedge funds to the S&P 500, which is a 100% long-only U.S. stock index. Does the list above look like they are all investing in large-cap U.S. stocks? (For related reading, see: What Are Hedge Funds?)
Common Principles and Business Strategies for Hedge Funds
Investors interested in hedge funds also tend to ask, "What are common principles and business strategies that most hedge funds abide by?” The following is a start:
- Low regulatory oversight: Many hedge funds are now registered with the SEC, but rules regarding disclosure are still low as compared to many other types of investment funds.
- Low liquidity: Normally hedge funds only offer quarterly liquidity, but with a 90-day or longer notice. Additional restrictions can also generally be imposed by the manager as they deem appropriate.
- High levels of leverage: Many hedge funds borrow money using an investor’s assets as collateral. They use these funds to then increase the size of their investment positions or “bets,” as many inside the industry call it (example: a $100 million fund could have $150 million invested in the stock market, with $50 million being a loan due to a third party regardless of the performance of the bet). Leverage can add to returns, but if the market goes the wrong way, it can quickly create large losses.
- High levels of tax-inefficient short-term capital gains: Many funds generate the majority of their gains in the form of short-term capital gains, which can be taxed at 50% or more in some states. (For related reading, see: Hedge Fund Returns and Taxes.)
- High fees: It's common to pay 2% per year of assets under management plus 20% of all profits over a certain hurdle rate (it is often said that the term hedge fund represents a compensation scheme rather than any set strategy).
- Low levels of transparency: Many funds will not allow investors access to detailed data on their holdings, information on changes in their strategies or total fees (sometimes additional investor expenses are disclosed only in fine print).
I believe some talented managers can add value and I have many friends in the hedge fund business who deserve to be compensated well, if they can add value as compared to an appropriate index after all fees, taxes and after adjusting for the lack of transparency and liquidity (yes, sorry guys, but big “if” list).
Before anyone gets too curious or invests in any type of hedge fund, I recommend they consider all the facts (including those listed above). To learn more, please consider reading the following:
- How to Invest Better, Again (includes section on FACTS and links to other articles in a series)
- Hedge Fund Returns and Taxes (includes advice on hedge funds from Warren Buffett)
As you can probably tell, I’m quite passionate about this subject and the need for increased investor transparency related to how complex investment strategies such as hedge funds are presented and sold.
(For more from this author, see: How Active Investing Leads Investors to Index Funds.)