Do hedge funds serve their purpose?

“…Many hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of investment loss.” – SEC, Hedging your bets: a heads up on hedge funds and funds of hedge funds.

“A hedge fund is an actively managed investment fund that seeks attractive absolute return…. Hedge fund managers are active managers seeking absolute return.” – Robert A. Jaegar, All About Hedge Funds (2003)

“Hedge funds are alternative investments using pooled funds that may use a number of different strategies in order to earn active return, or alpha, for their investors.” – Investopedia

To summarize, the ultimate purpose of hedge fund is to earn attractive return, preferably seeking positive alpha and that’s how the hedge fund managers market their fund – making positive alpha. But are the funds serving this purpose? Do they really make above market returns every year? Have these funds been able to beat the market in the long term, say 5 years, 10 years?

To come up with an answer requires some study since hedge funds are mostly limited partnership and free from all the regulation that mutual funds are subject to, Hence there is limited information about the short/long term performance of the funds.

Morningstar Broad Hedge Fund, which encompasses more than 500 hedge funds serves as a useful index for benchmarking and is also a good estimate of performance of hedge funds. Based on annual return starting 2009 through 2014, the historical rate of return for this index has been 4.3%. At the same time, it has been 10.5% for S&P 500.

Year 2014 2013 2012 2011 2010 2009
MBHF 16.46 20.56 1.77 0.14 6.12 11.77
S&P 500 11.39 29.6 13.49 0 12.78 23.45

(Data extracted from Morningstar)

Even when individual years are compared, hedge funds have been able to beat S&P 500 only 2 out of 6 times. So even though investing in the market seems a viable investment compared to hedge fund, still hedge funds are popular and attract investments from accredited investors. The popularity for hedge funds can be associated to these causes: Gains are announced. Out of the many existing hedge funds, there are few standout firms that are earning substantial returns, sometimes even during market turmoil. These are the funds that get media coverages, thereby garnering attention. On the other side, limited regulatory requirement means limited disclosure of information i.e. no need to publicize losses. A decent bet. Hedge fund are essentially a good lottery to bet on. Since its open only for accredited investors, they won’t feel as much financial pain as would a non-accredited investor. On the up side, you have better chance in winning in a hedge fund than in winning a lottery ticket.

In essence, hedge funds do not serve the purpose they are supposed to serve. However, given the limitation of data, it is necessary to further assess this scenario with sufficient data to support this conclusion.

The black swan hedge funds – A fund in need?

When non-finance people first read through this title, most of them must have recalled the academy award winning performance of Natalie Portman in Black Swan. Even for finance majors, they might be tempted to find linkage between the movie and hedge funds, like I did when I first came across this term in Wall Street Journal. However, in finance, “A black swan is highly improbable event with three principal characteristics: it is unpredictable, it carries a massive index and after the fact, we concoct an explanation that makes it appear less random and more predictable than it was.” (Taleb, 2007). Although unpredictable, at least in terms of when exactly such event may occur, however, there are funds that can offer protection. And you guessed it right, those are the Black Swan Hedge Funds (BSHFs).

Nasim Taleb first popularized the term “Black Swan” in his book The Black Swan – The Impact of a Highly Improbable, which is a NY Times best seller. The author currently works as an advisor to Universa Investments that sells BSHFs. According to Business Insider, a BSHF suggested by Taleb made a billion dollar last week.

The underlying mechanism of such hedge fund is simple. Buy a put option whose value rises high when the market falls. If the market is stable or increasing, one only pays the price of put option, which is analogous to premium paid to insure against risk. For the inflow of money to the investors,the market has to fall. Eg. 2007/08 Financial Crisis, 2010 Flash Crash. These are times when BSHFs come into limelight as word is spread that certain funds have earned millions of dollar while the rest are losing.

They BSHF can be seen as type of insurance policy to hedge against risk. It basically operates using a person’s emotion of fear and greed. And it is a good bet. It’s a win-win situation for both the parties. The firm gets a hefty fee for its service and the customer is insured against the downfall risk. When the firm is bullish, such firm can utilize public’s emotion of fear. Highlighting the past financial crisis and the amount of money that one can lose when the market turns red, these firms can market itself. It’s even easier when the market is bearish. Firms get a lot of publicity as news about so and so firm making so and so amount of money amid such turmoil. As is the case currently, BSHFs are getting ample coverage that has attracted investors who lost money.

So is it a friend in need? At the moment, yes. With the second largest economy taking a hit, emerging markets slowdown, influential CEO of Bridgewater Associates, Ray Dalio, predicting a round of Quantitative easing rather than interest rate hike and a lack of a clear understanding on the Fed’s stand on the interest rate, BSHF seems a viable tool to hold in the short run. However, in the long run, just as the Black Swan events are unpredictable, so is the decision to invest in BSHF. It all depends on one’s personal preference i.e. how much are you willing to pay and till when?