This is a question many investors are voicing, both institutional and retail. Understandably, this is a top of mind concern, given the returns averaged by the industry in the last three years. The S&P 500 experienced around 29 percent growth in those three years, while hedge funds saw gains midway between 7 and 8 percent. Even bonds enjoyed returns in the 13 percent range, also outperforming hedge funds over those same three years.
Regardless of how one views the validity of the S&P 500 as a benchmark, it is difficult to find a persuasive argument for not asking the question.
High net worth individuals, while not the bread and butter of the hedge fund industry, continue to be encouraged by their financial advisors to invest around nine percent of their assets in hedge funds. The arguments for doing so are persuasive.
Finding the Right Hedge Fund
Many believe that finding the right fund means finding a hedge fund manager that actually hedges. Far too many hedge funds have lost sight of their principal purpose, to guard against the loss of capital, and have instead, made the pursuit of outsized gains their principal purpose.
Institutional investors must also make a similar choice, capital preservation vs. the pursuit of gains. Of course, there is also the question of fees, which have been the subject of increasing derision. The volume of negative press regarding hedge fund management and performance fees has increased in proportion to hedge funds’ failure to achieve expected returns.
Unlike high net worth individuals, institutional investors feel the pressure of negative press in ways individuals do not. Individual investors have themselves and their families to answer to, whereas the institutional investment manager must justify his/her decisions to a board of trustees, directors and/or a cadre of other managing/meddling souls.
What Does This Mean for Hedge Fund Investment in 2017?
The year 2016 has been witness to shrinking numbers of hedge fund starts that failed to outpace hedge fund closures for the first time since the end of the financial crisis. Additionally, 2016 was the first year since the financial crisis to see negative flows from the hedge fund industry. As previously mentioned, 2016 was also the third straight year of underperformance.
The level of hedge investment for 2017 is decidedly an unknown at this point. However, we can look to the high percentage of redeemed capital that investors returned to higher performing hedge fund firms to provide a clue. The fact that the number of hedge fund firms may continue to decline is actually a non-event. The industry can only benefit as nonperforming funds fall to the wayside absorbing the assets under management once held by these failing firms.
Investment always means risk, without which there can be no return. As the industry undergoes this natural selection process, the chances investors will land a competent firm increase. The better solution, of course, is for investors to opt for hedge funds that hedge.