A persistent bull market, in part, has resulted in hedge fund performance falling short of the broader market. Colloquial wisdom suggests that investors have the potential to earn superior returns and enjoy lower fees by investing in mutual funds. In short, many outside observers believe investors are not getting what they paid for—it’s like going to Chez Paul’s for dinner and being served a Big Mac and fries.
Hedge fund managers counter that their primary responsibility is to preserve client capital and such comparisons to broader stock indices are inappropriate, if not outright unfair. They warn that when the markets turn bearish, they will be vindicated.
Hedge fund managers face problems with this argument because hedge fund underperformance is not limited to stock indices. Hedge funds are also underperforming low-cost, balanced mutual funds. These mutual funds are composed of stock and conservative investments such as bonds, which is not dissimilar to strategies employed by a number of hedge funds.
Regardless of these troublesome facts, hedge funds continue to grow assets under management at a rapid pace, more than doubling since the financial meltdown six years ago.
Why Will Hedge Fund Assets Under Management Continue to Grow?
The answer to the question of why hedge funds continue to attract the lion’s share of the alternative investment dollar is the combined impact of three factors:
1.) Fully 65% of the $1.76 trillion invested in North American hedge funds is invested by institutional investors, largely corporate and public pension funds, insurance companies, endowments and foundations. Investors of this stripe are understandably risk-averse. This statistically significant group of investors is willing to accept modest growth in exchange for capital preservation. As a result, hedge funds have become increasingly conservative, a natural response constructed to meet client expectations, which has had the equally predictable result of increasing assets under management.
2.) Imagine yourself as a well-paid public pension fund’s investment officer suggesting something as mundane as an investment in mutual funds. Really? Why should an individual pull down a six-figure salary for an investment strategy practiced by the masses? Once again, the mystique of a hedge fund investment plays a critical role. The assumption being that hedge fund investment requires a level of skill and expertise which justifies such compensation.
3.) Fears of market volatility increase in direct proportion to the length of time a bull market persists. Volatility concerns propel investors into the waiting arms of hedge funds and its promise of capital preservation. The longer the bull runs, the more intense becomes the sentiment for hedge fund investment.
What Will the Future Bring?
Although hedge fund returns have been disappointing, there is nothing on the horizon to diminish the excellent prospects for hedge fund growth in 2015. On the contrary—the industry is reaping the benefits of a “perfect storm”. An already risk-averse client base, with no plausible alternative investment, driven by the increasing probability of a downturn will, once more into the breach, with its hedge fund partners leading the charge.