SprottWealth Insights

The misunderstood hedge fund

Due to their perceived risks and limited regulation, only accredited investors are typically allowed to invest in hedge funds. Please contact your SprottWealth advisor to discuss your eligibility.

Hedge funds conjure up images of George Soros, Stan Druckenmiller, Kyle Bass and other star money managers, whose successes (and failures) have been widely chronicled in the public press. With good reason of course, as the sector is growing. According to the 2016 Preqin Global Hedge Fund Report1, the sector comprised USD $3.2 trillion of assets under management as of November 2015, having added $71.5 billion of new capital inflows in 2015.

Hedge funds offer the highest risk/return profile of all alternative asset classes. The nature of those returns, which tend to be uncorrelated with those of traditional asset classes, make them a popular option with “smart money” investors, particularly high net worth individuals and institutional money. The category’s reach has broadened in recent years among retail investors seeking protection from inflation, macro-economic uncertainty, volatility, and among those who want to generate income in a low-yield environment.

Hedge funds remain largely misunderstood because they are less regulated than traditional investment tools and they operate with less transparency. However, there are good reasons for both practices.

Many categories of hedge funds

Hedge funds invest in a wide variety of asset classes. These generally include equities and fixed income securities, but they can also leverage a broader range of instruments and strategies related to commodities, derivatives, currencies, sovereign debt and more. Common hedge-fund strategies include long-short, market neutral, event-driven, and global macro2.

Reducing market volatility

Hedge funds were pioneered by Alfred Winslow Jones, a manager who wanted a vehicle that would enable investors to combine long-holdings in promising stocks with short positions in less-promising issues. This two-pronged approach was designed to reduce the violent swings that affect broader instruments, which today notably include ETFs. Jones also introduced leverage tools to enhance asset returns and incentive fees to enable him to attract top investment management talent.

Hedge fund performance is impacted by a number of elements. These include interest rates, economic and sector performance, geopolitical events, as well as asset class volatility. The uncorrelated nature of hedge fund returns provides diversification and thus protection during market downturns. The table below compares hedge fund performance with that of the broad market during the five most recent market crises.

Hedge funds: HFRI Fund Weighted Composite Index. World stocks: MSCI World Net Total Return hedged to USD. Source: Bloomberg, MSCI, Man Group

Less regulated, less transparent

Hedge funds are structured in such a way as to avoid the strict regulations imposed upon mutual funds. Mutual fund regulations were designed to protect individuals who do not have the time or the funds to leverage more sophisticated strategies. The hedge fund structure is thus better suited for more experienced and accredited investors, who want access to opportunities not available to the general public.

The lack of transparency surrounding some hedge fund strategies and holdings exists for a reason. Many of the sector’s key managers do not want their proprietary strategies divulged, as they believe it might impact their competitive advantage.

A time for hedging?

Since many hedge funds are designed to operate counter-cyclically, the most conducive environments for them include: higher interest rates, higher market volatility and medium-to-low correlations between different asset classes (e.g. between stocks and bonds). Such environments have not existed in many years, which is why returns in the category have been modest lately.

That said, the ultra-loose monetary policy favored by global central banks in recent years, which has boosted general asset prices across the board and pummeled interest rates, has created new openings for fund operators, many of whom have designed specific products to hedge the risks inherent in such an environment.

To learn more about how you can use hedge funds to smooth out your portfolio risks and boost long-term returns, please contact your Sprott Wealth advisor.

1 https://www.preqin.com/docs/samples/2016-Preqin-Global-Hedge-Fund-Report-Sample-Pages.pdf
2 http://www.investopedia.com/walkthrough/fund-guide/uit-hedge-fund-reit/hf/types-of-hedge-funds.aspx