Over the past few decades, hedge funds have transitioned from being obscure investment vehicles to an increasingly well-known investment vehicle as demonstrated by growth in assets under management. Global assets under management within the alternative investment industry totaled $7.4 trillion in the first half of 2016, according to data provider Preqin. As a subset of the alternative investments category, hedge fund assets surpassed the $3 trillion milestone for the first time by YE 2016 according to the HFR Global Hedge Fund Industry Report. As some institutional investors such as public pension plans have struggled to make up significant shortfalls in the amount of money they are legally required to pay out to retirees, many have turned to hedge funds over time in search of higher returns for the money they invest1. In markets where straightforward debt or equity investments can make generating returns extremely difficult, such as the lingering low-interest rate environment that has existed since the 2008 credit crisis, hedge funds may provide investors with an alternate investment path as well as an added means to diversify overall portfolio risk. 2016 has proven to be a year which has seen both meaningful outflows from hedge funds as well as record levels of invested assets2. As such, we believe the year serves as an important reminder for independent financial advisors to reflect on their understanding of hedge funds as an investment opportunity that might serve their clients’ goals, as hedge funds are no longer the sole province of institutional investors.
Like mutual funds, hedge funds typically use the pooled capital of multiple investors to create a single diversified investment portfolio focused on generating the largest possible returns for the individuals that have invested in them. Though there is a range of investment strategies employed by hedge funds, the one thing that generally ties many of them together is the practice of hedging – using one investment position to offset the potential losses of another position while reducing an investment portfolio’s overall risk in the process.
Through the practice of hedging, hedge funds generally seek to avoid correlation with standard market indices like the S&P 500. If the equity market experiences volatility that causes a downturn, the impact to the hedge fund’s performance may not be as severe and in fact performance might improve if negative correlation to the equity markets was the intent of the fund’s strategy. In this manner, hedge funds can provide balance and diversity across portfolios containing diverse asset classes, particularly those of high net worth clients.
Unlike mutual funds, which generally must adhere to strict limitations on the amount of risk (or leverage) that they can take within their investment portfolios, hedge funds can typically exercise discretion over their investment allocations and are therefore able to use far more sophisticated and aggressive investment approaches in their quest for higher returns. The most basic hedge fund strategy is long/short equity, where a fund manager will take long positions in stocks that they expect to increase in value, while at the same time taking short positions in stocks expected to drop in value. By altering the balance of long and short positions within a portfolio, a fund manager generally seeks to control a fund’s overall exposure to market risk. The types of hedges employed by fund managers run the gamut, from the previous example to the use of more sophisticated financial instruments such as the use of put or call options, derivatives, commodities and futures contracts, among others. Some hedge funds also employ large amounts of leverage; in exchange for assuming greater levels of leverage or risk, hedge fund investors expect to be rewarded with higher returns than those generated by the average mutual fund or market index. Due to that added risk, the Securities and Exchange Commission only allows investments in hedge funds to be made by investors that meet specific criteria. One category of investor in this regard is the accredited investor, which includes an individual with a sophisticated understanding of investing and whose net worth is in excess of $1 million, excluding their primary residence, among other qualifications. A more stringent category of investor typically required by hedge funds is the qualified purchaser, which includes an investor who owns not less than $ 5,000,000 in investments. Hedge fund investors also need to be prepared to agree to lockups –periods of time during which they are unable to redeem their investment so that fund managers have the time to put money to work in illiquid investments without the need to sell at less than optimal prices in order to meet redemption requests.
While the record levels of capital invested in hedge funds is a positive indicator, for many, 2016 was a challenging year in which overall performance was inconsistent. Despite fund managers’ best efforts to hedge against risk and potential market downturns, there can be a wide variance in the performance of different hedge fund investment strategies. In their search for better returns amidst varying market conditions, some fund managers strayed from their core strategies with mixed results. As an example, in the first quarter of 2016, Preqin’s All-Strategies Hedge Fund benchmark index recorded a loss of -0.43%. Fortunately, certain strategies managed to do well and the hedge fund industry’s overall performance has consistently improved since, with the Preqin’s All-Strategies Hedge Fund benchmark returning 2.15% for the second quarter of 2016, and 4.0% for third quarter 2016. While many hedge funds once again seem to be on an upswing, some institutional investors decided to decrease their hedge fund exposure in 2016, although we believe the record level of hedge fund assets recorded in 3Q2016 demonstrates that performance gains have outmatched asset outflows. Many other institutions continue to increase their exposure, aware that attractive investment opportunities may exist but that proper due diligence remains key.
When considering hedge fund opportunities for their clients, we believe independent wealth managers must exercise even greater levels of selectivity and diligence than institutions do as their clients are relying on them to serve as alternative investment experts. Many advisors need tools and assistance to help them to deliver on that promise and to navigate the complexities of the hedge fund environment. It is not uncommon for the minimum investment required for a fund to be measured in the millions, and even then access to some of the hedge funds with the longest and best track records is typically restricted to the largest of institutions. It is with respect to these considerations that we believe financial advisors who use the CAIS platform can see the platform’s benefits most clearly. As an open-architecture platform, CAIS has curated what it believes to be premier hedge fund investment opportunities that would ordinarily be inaccessible to independent wealth managers and has made them accessible by harnessing the power of aggregated advisor demand. The collective buying power of the independent wealth channel is a factor in allowing CAIS to offer lower investment minimums for advisors and their clients. CAIS’s partnership with Mercer, a leading independent third-party due diligence provider, provides an objective view of the funds offered to lessen an advisor’s selection burden. In addition, CAIS members benefit from Mercer’s regular market research coupled with invitations to exclusive fund manager and thought leadership events on an ongoing basis. Automated subscription documents and custodial integration combine to make the investment process a more streamlined and straightforward experience from end to end.
In attempting to capture the attention of high net-worth clients from much larger institutions as well as the evolving robo-advisor landscape, we believe independent wealth managers need to differentiate themselves as experts in an array of investment strategies and opportunities in order to be successful. Alternative investments, and hedge funds in particular, can complement that differentiation. Savvy wealth managers should reflect on that potential and seek the knowledge and support that they require to capitalize upon it as appropriate.
1.AGECROFT Partners, LLC, Pension Fund Evolution of Hedge Fund Investing, 2013
2.Hedgefundresearch.com, Hedge Fund Capital Rises To Record in 3Q, October, 2016
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