The performance of the S&P 500 is on a par with real ten-year Treasury rates yet, many financial reporters prefer to focus on hedge fund performance, going so far as to suggest they are imploding which, by definition, means a sudden and complete failure.
While it is true that not every hedge fund develops and pursues a successful strategy, to suggest hedge funds are imploding is blatant hyperbole—not news!
The strength of the hedge fund industry lies in its ability to innovate. Hedge funds are the vast experimental laboratory of financial innovation. Some of these experiments are wildly successful … others are dismal failures and, most fall somewhere between these extremes.
Do the Critics Have It Right?
Hedge fund returns have been unimpressive. In fact hedge fund returns, in the aggregate, are at the lowest levels since the financial crisis. Although this could turn on a dime, it isn’t likely that hedge funds, on average, will have a stellar 2015 in the gains department.
Yet, Goldman Sachs has plans to invest $1.3 billion in hedge funds via minority stakes across a broad spectrum of select firms. Has Goldman Sachs lost its collective mind? Of course not! This is the second iteration of the Petershill Fund which Goldman Sachs deployed in 2007. Regardless of your views on Goldman Sachs, everyone can agree that it would not revisit this strategy had the first venture not been successful.
What hedge fund critics so frequently fail to acknowledge is that wealth creation is not a hedge fund’s primary goal. The first duty of a hedge fund is to preserve wealth. Hedge funds were never intended to be the vehicle of choice for the investor seeking to build a retirement fund, a nest-egg for that dream vacation or for the nice young couple saving for their first home. On the contrary, hedge funds were conceived to protect wealth previously created and yes, grow it to the extent possible in a risk-averse paradigm.
Capital Preservation and Growth
Capital preservation is not typically compatible with growth. The rule of the thumb for investors has always been, the greater the risk, the greater the reward. This is the dilemma faced by every hedge fund manager and, for that matter, every investor.
Like heart surgeons, some hedge fund managers exhibit more skill than others. When choosing a doctor to perform a quadruple bypass, it pays to look into the track record, educational background and reputation of the surgeon. Similar due diligence is required when choosing a hedge fund.
It is no more appropriate to trash the whole medical profession when a bypass surgery goes awry than it is acceptable to disparage the entire hedge fund industry when a hedge fund fails to meet expectations. In the end, it is all about risk management.
Institutional investors, pension fund managers and high net worth individuals turn to hedge funds first for risk mitigation, and second for potential gains. If gains were the prime objective, we would not see them invested in hedge funds.