Why do people invest in hedge funds?

Hello,

I would like to discuss the interest of hedge fund investing with you guys.
I noticed that an overwhelming majority of hedge funds were losers (not able to beat their benchmark), and so wondered why would some investors put them in their portfolios despite the incredibly expensive fees : If fees + low liquidity were accounted for I'm not sure we could count on our fingers how many hedge funds can beat their benchmark.
Some people say hedge funds are a good investment as a hedge for downside risk because of their low volatility and reputation for good performance during bear markets, however can't we just short the index instead?

I'm not trying to taunt hedge fund people, I'm just wondering and figured some of you could give me an answer I would be satisfied with.

Thanks!

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Comments (32)

Most Helpful
May 4, 2020 - 4:36pm

I don't think it is correct that the overwhelming majority of hedge funds were unable to beat their benchmarks. It really depends on the fund's liquidity and exposure to the market. If a hedge fund is very liquid and takes 0 or close to 0 beta exposure (i.e. market neutral L/S equity funds) the benchmark would be 3 month treasury bonds. In the recent past, 3 month treasury bills yield something like 1-2%? So market neutral funds that beat that after fees are beating their benchmark.

Also there are lots of hedge funds out there. Most are indeed very crappy/small. If you weight the returns of hedge funds by their assets under management (similar to weighting stocks in an index by their market cap) hedge funds definitely outperform.

Biggest weights in such an index would be to Bridgewater, Renaissance, Citadel, Millennium, Two Sigma, Point72, Man Group, DE Shaw, and others. Even after accounting for survivorship bias, an index holding assets in these hedge funds would have substantially outperformed almost any appropriate benchmark.

May 4, 2020 - 5:01pm

I saw this in a Forbes article (to explain my statement):
"As I digested this I reflected on a hedge fund survey published this January in FTfm, which screened over 900 hedge funds managing assets from $100m to $1bn through data provided by BarclayHedge. The performance table at the foot of the survey revealed that just one of the top five hedge funds profiled outperformed the S&P 500 total return index over a one-year period."

But do you think the biggest funds can compete with the S&P500 if the fees are taken into account? Even with the most basic 2 & 20% fees: for a hundred dollars invested, if your hedge fund returns 20% you only get $114 (so you really get 14%).
And we know that the biggest fungs probably ask way more.

  • Associate 2 in HF - Other
May 5, 2020 - 10:48pm

Shhhhhh......stop killing our industry lol. it's true though that the vast majority of hedge funds underperform the S&P, but volatility is something that also needs to be taken into account. most hedge funds do not have nearly the amount of volatility pure S&P long exposure has. for institutional investors like pension funds that need some stability etc. shit that individual people yolo'ing in PA's don't need - hedge funds can be an attractive option. but the vast majority of investors don't need hedge funds and just parking your money in the s&p for 30 years will make you much happier.

this is also why so many funds fail and are crappy but the ones that can consistently be good are the giants of the industry that consolidate and retain their 2/20 AUM and even charge more than that. DE Shaw is like 3/30 or something. renaissance deserves to be 5/50. it's a damn hard industry to be successful in but if you do the rewards reflect your value amongst the rest of the space.

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May 6, 2020 - 8:22am

Some truth here. But bridgewater hasn't been an index for a long time. Equity index would obviously be wrong but their ask risks greater than tbills.

RenTech you can't invest in. That's almost like saying go invest in drw or jump trading which IMO is basically their comp/index. Or much closer to it.

The rest of your list I would agree have beaten their index. Though tbills is too low. Many of those firms seem to have overall performance that has some beta.

May 6, 2020 - 11:27am

Renaissance has a couple funds you can still invest in that have been pretty good but not as good as medallion. There are like 10 other funds of similar size that i could have mentioned that would be in such an index that have outperformed.

And yeah t bills would be the lower threshold. but from an asset allocation perspective that's how LPs think of market neutral L/S.

May 6, 2020 - 7:48pm

Yes there other funds are more scalable and seem to be better.

And of course non of those are pure tbills almost all have some beta or exposure to other factor including citadel (which is probably the lowest based on returns).

May 4, 2020 - 4:42pm

One reason could be that hedge funds are not subject to the same or as many regulations

Array
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May 6, 2020 - 11:19am

Special situations. How would you as an investor get access to a special situation and understand what was going on and how to make money from it?

Offshore liffe
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May 5, 2020 - 3:47am

Hedge funds are meant to hedge; that is generating returns in any market conditions (that is, they seek absolute return, not relative return -return compared to a benchmark-). The idea is that they have to overperform the markets in bearish periods and do well in bullish periods. Do they do it?

By far yes, they have hugely overperformed the markets in bearish periods. What is the problem? When you have the FED printing money like if it was the end of the world for over a decade and you have the largest bullish period in history, then if you are conceived to do better in bearish periods, then you have a problem.

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May 5, 2020 - 9:05am

The answer is that a lot of investors aren't investing in them anymore, a trend that will continue in the years to come. The top funds will continue to do well and generate strong returns net of fees (and taxes, which is increasingly important post-TCJA due to lack of deductibility for certain things). The rest will fall by the wayside as investors realize their real net returns are not worth the risk and illiquidity.

May 5, 2020 - 4:13pm

Majority of funds are losers but that's probably less true on a weighted basis. E.g. if there's 70 losers and 30 winners but the 30 winners manage more money, then the avg client may still be beating the market even as most funds lose.

Idk if that's the case, but I've noticed the "hedge funds underperform" crowd always acts like they're so mathematically detailed, and yet they never do a weighted average of returns. Should always be skeptical when you see that.

But let's say even on a weighted average, most funds lose.

Even if most funds lose, maybe you're still capable of picking a winning manager. There is a whole industry of allocators and consultants who are paid to do that. So even as they tell you most funds underperform, they're also glad (for a fee) to tell you which ones won't.

If they can do it, you probably can too.

You asked why not just short the index. Its not as good a trade because if you have a handful of co's that are overvalued, those can offer you both a hedging effect and an overall alpha effect (i.e. they can go down even when the market is up). Shorting the index if you don't think its overvalued is basically just buying expensive insurance.

May 5, 2020 - 7:07pm

What do the next five to ten years hold for hedge funds? What I'm trying to ask is, for an ambitious future investor who wants to manage other people's money, what strategies in the hedge fund world do you see succeeding in the future? I think we can all agree quants will be very successful, but what about macro, distressed, event-driven, emerging markets etc.?

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May 5, 2020 - 7:44pm

Can we all agree that quants will be very successful?

1) they rely on significant leverage which may not be available and even when it is, subjects them to deleveraging events. We've seen it time and time again.

2) quant strategies largely correlate. There are various flavors but they're broadly looking at similar factors and building similar models.

3) quant has become an arms race. The largest access to computing power and brainpower will win and everyone else will lose.

May 6, 2020 - 11:41am

I think i'll just buy myself a dart throwing monkey hehehe! x)
Not kidding there's really a study on this which you can find online.
Thanks for your answer Rahma, do you perhaps know what is the average return of the biggest funds net of fees?

May 6, 2020 - 12:27pm

There's endless studies on it. It won a Nobel Prize for Fama. But I haven't seen a weighted average one yet.

Not sure what the returns of the biggest funds are, but time period will be everything. I'm sure they're crushing the S&P this year for example, and I'm also sure they've been getting crushed by the S&P for the last decade.

Risk-adjusted returns are what count anyways. If a fund has low risk, you can put all your money in. S&P has nice returns but few people would put all their money in.

May 6, 2020 - 8:59am

I am a private banking client that has just sold my family business (because my sons are too spoiled and stupid to run it) for USD 100m. I require USD 5 m p.a. to run my family (wife, kids, mistress, etc.). I have no interest in what the S&P 500/SXXP 600 does, I just need you to deliver 5% annually (plus inflation) without losing my money. If you can do that for me I am happy to pay you 1% plus a percentage of performance over a hurdle rate......

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