First: Do No Harm

August 17, 2014

There are equivalencies that can be drawn between the physician’s Hippocratic Oath to patients, and the hedge fund’s primary responsibility to its clientele.

Just as the physician pledges to do no harm, the hedge fund manager has a similar charge with respect to preserving the investor’s capital. Don’t lose any principal! Of course, along with the concept of hedge funds as preservers of wealth, is the notion that hedge funds are multipliers of wealth.

While these two objectives are not mutually exclusive, the client’s focus on capital preservation in volatile markets, and expectations of growth in all market conditions are a significant challenge for any hedge fund manager.

In the Beginning

Alfred Winslow Jones, credited with founding the first hedged fund in 1949, was focused on investing in a manner that avoided wild swings in the market. In short, protecting invested funds against market volatility was the fund’s foremost goal. This was achieved by employing the now classic equity long-short strategy.

Hedge Funds in the Short-term

Recently, hedge funds have been on the receiving end of significant criticism because many are under-performing as compared to an arbitrary benchmark index—the S&P 500. Often overlooked, is the fact that a significant percentage of so-called hedge funds, are not “hedged” at all. The more than 10,000 funds in existence employ a variety of strategies other than long-short and would be unrecognizable as hedged funds by the esteemed Mr. Jones. Even so, the long view of hedge funds reveals a record that beats the performance of the S&P 500.

Looking back over the past twenty-years, S&P 500 annualized returns stand at 7.13%. In contrast, HFRI’s weighted composite of all hedge funds, regardless of strategy, delivered annualized returns of 8.84%. Equity hedge fund performance, viewed in the aggregate over the same period, demonstrates annualized returns of 10.3% … more than 3% ahead of the S&P 500.

Here’s the Point

Hedge fund managers do not rise from their nightly slumbers bent on the mission of beating the S&P 500 index. In fact, most who invest in hedge funds do not have beating the S&P 500 as their principal objective. All too frequently, the S&P 500 is the “go-to” index for those in the media struggling to understand hedge fund performance. While the S&P 500 is an important benchmark, it is not the yardstick by which most hedge fund investors gauge the performance of their chosen fund.

The quality of any hedge fund’s performance is best determined by its investors. Investors have a variety of goals and clearly defined expectations from their hedge fund investment. For example, many investors value the lower volatility that hedge funds provide. Others seek down-side protection and enhanced diversification, while still others view their hedge fund investment as a complement to their existing investment strategies. Obviously, none of these examples have strong ties to the S&P 500.

The bottom-line is that a variety of hedge funds, pursuing a plethora of strategies, cater to the diverse needs of investors. Rarely are those needs defined as outperforming the S&P 500.

 

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Most following the hedge fund industry are acutely aware that globally, hedge funds have more than $2.2 trillion in assets under management (AUM). This is a staggering sum by any measure and it continues to grow quarter over quarter. However, mutual funds remain the single largest draw for investor dollars, with $30 trillion in AUM world-wide, $15 trillion of which reside in the United States.

This roughly fifteen-fold disparity is the consequence of many factors, not the least of which is the wealth test that potential hedge fund investors must pass to join the club. Although the JOBS Act has liberated hedge funds from the shackles of the ban on general solicitation, it has not eased the membership requirements for participation. As a result, the soup du jour for the majority of retail investors will continue to be mutual funds. However, a substantial number of mutual fund investors are capable of meeting the required criteria for transition to a hedge fund.

The Hedge Fund Mystique

Let’s face it – mutual funds are terribly dull. Moreover, mutual funds do not enjoy the mystique associated with hedge funds. Astute, market savvy mutual fund managers recognize that absent the ban on general solicitation, there is a very real possibility of losing investors to the comparatively provocative world of hedge fund investing. Hedge fund managers should be working aggressively to make that happen—but very few are making the effort.

In contrast, more than a few proactive mutual fund managers have taken steps to recast their fund’s image in a manner that more closely mirrors strategies employed by hedge funds, yet requiring asset minimums as low as $1,000.

For example, mutual funds such as State Street Global Advisors, enabled by the repeal of the so-called short rule, launched a fund with a hedge-sounding name, Global Alpha Edge, which featured a blend of long and short positions, even before the solicitation ban was lifted. Other mutual funds are being offered to investors as “market-neutral”, implying returns in good times and bad. There are also mutual funds offering a “fund of funds” approach.

These imitations, although flattering, should be serving as a clarion call to hedge fund managers. If mutual funds are concerned enough about client retention to mimic hedge fund rivals, then it stands to reason that genuine opportunities exist for hedge funds to capture some percentage of this lucrative retail market … some percentage of $30 trillion.

Efforts Disappoint

To date, there is little evidence that hedge funds are making any serious effort to turn qualifying mutual fund investors into hedge fund investors. The reticence is understandable. The decades-long ban on solicitation has a momentum that is difficult to overcome.  Add to the equation the fact that most hedge fund managers look at the cost/benefit of marketing with the same analytic mindset employed in evaluating an investment and it isn’t helpful that the ROI for marketing costs is a significant unknown in the hedge fund industry.

With trillions of dollars in play, hedge funds must overcome these concerns and forge ahead. The retail market is huge and every effort should be made to tap it.

 

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