Who Invests in Hedge Funds and Why?
The primary investors in hedge funds are institutional investors. These are professional investors who manage large amounts of cash. They work for pension funds for corporations, government workers, and labor unions. They also manage sovereign wealth funds for entire countries. They handle the cash assets of insurance companies, corporations, and trust funds. Institutional investors provide 65 percent of the capital invested in hedge funds.
Hedge fund investors are required to have at least $1 million in net worth. They need this cushion to weather significant downturns in their portfolio in their quest for higher returns. They've also got to be able to keep their money tied up for the three or more months required by hedge funds. In fact, more than half have a three-year time frame.
They often must be willing to pay 2 percent of the assets they invested and 20 percent of any profits. This high price is worth it to them to outperform the market. Some are still trying to recover losses incurred during the crash of 2008.
They are also sophisticated investors. They understand how leveraging works through options, futures contracts, and the other derivatives that hedge funds use to boost returns. They are willing to endure the risk when the investment goes south.
They've also got to be good judges of character. Most hedge funds don't reveal what they do to get their returns. That lack of transparency means they can actually be Ponzi schemes, such as the one run by Bernie Madoff.
Why They Invest in Hedge Funds
Those big investors put less than 20 percent of their assets into hedge funds. More conservative investors, like insurance companies, pension funds, and sovereign wealth funds, allocate less than 10 percent of their total investments.
They are looking for an investment that is uncorrelated with the rest of their investments. If the stock market loses value, the hedge fund investment will rise. In other words, they use hedge funds to increase their diversification. They know that a diversified portfolio will increase total returns over time by reducing overall volatility. For that reason, these investors don't compare the performance of their hedge fund investments to standard indices like the Standard & Poor’s 500, the NASDAQ or the Dow Jones.
Surprisingly, most hedge fund investors aren't looking for higher-than-average returns. Only 6 percent thought they could achieve 10 percent or more annual returns. They just aren't willing to endure the risk that higher returns entail. Instead, 67 percent are looking for annual returns of between 4 percent and 6 percent. That's probably because they have to report to boards which might fire them if they sustain losses.
Family trust funds use hedge funds to gain access to the best minds in the investment. Why do hedge funds attract the smartest investors? Because they pay the most. But 22 percent of investors said high fees are why they limit, or even avoid, hedge funds.
Pension funds recently started investing in hedge funds to boost returns. They realized they may not have the capital needed to cover the mass of retiring baby boomers and are trying to outperform the market to cover these obligations. Unfortunately, the risky nature of hedge funds and their lack of regulation mean these pension funds are less likely to cover their commitments.
But there is some indication that they are becoming less popular. In 2014, they returned only 3.3 percent on average, much lower than the S&P 500. Also, almost as many hedge funds are liquidated each year as are created. Many savvy investors realize they are taking all the risk, while the hedge funds aren't producing rewards to offset that risk.
The California Public Employees' Retirement System announced it would withdraw all of its $4 billion in hedge funds in 2014. It only received a 7.1 percent return in the last year. That sounds good until it's compared to the 12.5 percent return of a comparable investment, the Vanguard Balanced Index Fund. It has an asset allocation of 60 percent stocks and 40 percent bonds. Despite that, a confident 8 percent of hedge fund investors are either maintaining or increasing their allocations over the next 18 months.
(Source: "For Hedge Funds, a Troubling Return," The Wall Street Journal, September 17, 2014.)