Many of you who read our papers would qualify to invest in hedge funds. However, if your hedge fund portfolio resembles the average of the hedge fund universe, it is better to not invest in hedge funds at all. The reasons for individual investors to steer clear of hedge funds include:
Not diversifying – hedge funds repackage investment risks you already have
Vanished skill-based return – better to obtain similar investment exposure in a low cost way
Not “absolute return” – will experience losses, often at the worst times
Enormous fees – lucrative for the hedge fund manager but not for you
Not transparent – delayed and partial information about your holdings
Not liquid – takes a long time to get your money back
Very tax inefficient – large and unpredictable obligations for taxable investors
What is a Hedge Fund?
The term “hedge fund” covers dozens of types of investment strategies, with many subtypes within types. One common factor is an emphasis on active security selection – exploiting investment “mistakes” made by other participants in the markets.
Another common element to hedge funds is the regulatory structure. If a fund limits the number of its investors and all investors are “qualified” (affluent and presumably sophisticated) the fund manager is exempt from the regulations of the Investment Company Act of 1940 and its subsequent amendments and rules (often referred to as the “40 Act”). The 40 Act protects investors by requiring fund managers to regularly disclose information about their business, strategies, and investment holdings. Because hedge funds are exempt from the 40 Act, hedge fund investors have fewer protections.
Cliff Asness, head of AQR, once described hedge funds (2004): “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood.”
Despite these drawbacks, hedge funds continue to attract investor capital. Assets under management have grown steadily since the Global Financial Crisis, reaching $5 trillion by the end of 2023.[1]
Not Diversifying
Hedge funds are marketed as the ideal diversifying investment, a source of consistently positive investment outcomes not correlated to the equity market. The reality is that hedge funds, as a group, are an inefficient and expensive way to obtain more equity market exposure. Since 2010, the correlation of the monthly returns of the hedge fund index and the S&P 500 has been 0.75. Hedge funds are closer to perfectly correlated with equities (1.0 correlation) than uncorrelated (0.0). That high correlation might still be acceptable if the returns were high enough, but…
No Net Skill-Based Return
Since 2010, one could have replicated the performance of the hedge fund industry as a group at the same level of investment risk with a portfolio holding 35% in the S&P 500 index and 65% in three-month US Treasury bills. The following chart compares the cumulative returns of the two investment strategies. A strategy with 35% in the S&P 500 and 65% in cash would have returned 5.5% per year, while the hedge fund universe delivered only 4.1% per year. Because hedge fund reporting is biased upward, the true return was likely even worse. In retrospect, hedge funds delivered similar exposure with worse outcomes than a simple stock/cash mix.
Earlier, hedge funds generated more benefit relative to stocks – from 1993 to 2003 the hedge fund index returned 11.1% per year when the risk-equivalent US equity return was 8.3%. Perhaps hedge fund assets have since escalated much faster than the supply of investment “mistakes” to exploit.
Not “Absolute Return”
Another term often used for hedge funds is “absolute return,” implying positive returns in any environment. However, because hedge funds have a high correlation to the stock market, they typically lose money at the same time that the market does. The chart above shows the four largest drawdowns of the hedge fund index over the past 30 years — each coinciding with major stock market selloffs. The 1998 decline included the collapse of Long-Term Capital Management.
Enormous Fees
On average, hedge fund managers have skill. The problem is that more than all of the benefit of that skill ends up with the fund managers, leaving a losing proposition for clients. From 2010–2023, the hedge fund index returned 4.1% per year. A typical fee structure (1.5% management + 15% performance) means a gross return of 6.6% was required to net 4.1% after fees — nearly 40% of gains going to the manager. The result: investors underperform a simple stock allocation at equivalent risk.
The incentive structure also distorts behavior — small funds are rewarded for risky bets that might pay off, while large funds are rewarded for caution that preserves lucrative management fees. This “risk compression” over time has led to falling returns for hedge fund clients.
Not Transparent
Because hedge funds are exempt from the 40 Act, they disclose far less information. Holdings reports are delayed and incomplete, and investment strategies can shift without notice. This lack of transparency limits an investor’s ability to manage their overall portfolio risk effectively.
Liquidity Risk
Investors in hedge funds who change their mind often have to wait months to withdraw capital — usually three months to a year. Managers may also suspend redemptions. During the 2008–09 financial crisis, many investors were unable to withdraw their money at all.
Tax Inefficient
Hedge funds are particularly poor for taxable investors. Their high turnover generates mostly short-term capital gains — taxed at up to 37% federally and 13.3% in California. Investors also lack visibility into these obligations, often receiving K-1 forms too late to plan properly.
Who Should Invest in Hedge Funds?
Only investors who can identify the best managers in advance. The performance gap between top and median hedge funds exceeds 7.5% per year.[5] Large, institutional investors (e.g., university endowments) have the staff and access to conduct deep due diligence — meeting managers, analyzing strategies, and evaluating operations before investing. Individual investors lack such resources and are unlikely to select the winners consistently.
Summary
David Swensen, Yale’s legendary CIO, wrote in Unconventional Success[6] that individuals should not try to emulate institutional hedge fund strategies. His guidance: focus on diversified, low-cost portfolios of liquid asset classes. We agree. For most individual investors, hedge funds have been a long-term disappointment, and avoiding them entirely is often the best decision.
Disclaimer
The information and opinions contained in this article are for informational purposes only and do not constitute investment advice. Atlas Capital Advisors, Inc. does not guarantee the accuracy, completeness, or timeliness of this information and accepts no liability for any loss arising from its use. This material is not an offer or solicitation to buy or sell any security or investment product. Past performance is not indicative of future results. Investments are subject to risk, including the potential loss of principal.
What’s Discussed
Many of you who read our papers would qualify to invest in hedge funds. However, if your hedge fund portfolio resembles the average of the hedge fund universe, it is better to not invest in hedge funds at all. The reasons for individual investors to steer clear of hedge funds include:
What is a Hedge Fund?
The term “hedge fund” covers dozens of types of investment strategies, with many subtypes within types. One common factor is an emphasis on active security selection – exploiting investment “mistakes” made by other participants in the markets.
Another common element to hedge funds is the regulatory structure. If a fund limits the number of its investors and all investors are “qualified” (affluent and presumably sophisticated) the fund manager is exempt from the regulations of the Investment Company Act of 1940 and its subsequent amendments and rules (often referred to as the “40 Act”). The 40 Act protects investors by requiring fund managers to regularly disclose information about their business, strategies, and investment holdings. Because hedge funds are exempt from the 40 Act, hedge fund investors have fewer protections.
Cliff Asness, head of AQR, once described hedge funds (2004): “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has recently been making money. Every three or four years they deliver a one-in-a-hundred year flood.”
Despite these drawbacks, hedge funds continue to attract investor capital. Assets under management have grown steadily since the Global Financial Crisis, reaching $5 trillion by the end of 2023.[1]
Not Diversifying
Hedge funds are marketed as the ideal diversifying investment, a source of consistently positive investment outcomes not correlated to the equity market. The reality is that hedge funds, as a group, are an inefficient and expensive way to obtain more equity market exposure. Since 2010, the correlation of the monthly returns of the hedge fund index and the S&P 500 has been 0.75. Hedge funds are closer to perfectly correlated with equities (1.0 correlation) than uncorrelated (0.0). That high correlation might still be acceptable if the returns were high enough, but…
No Net Skill-Based Return
Since 2010, one could have replicated the performance of the hedge fund industry as a group at the same level of investment risk with a portfolio holding 35% in the S&P 500 index and 65% in three-month US Treasury bills. The following chart compares the cumulative returns of the two investment strategies. A strategy with 35% in the S&P 500 and 65% in cash would have returned 5.5% per year, while the hedge fund universe delivered only 4.1% per year. Because hedge fund reporting is biased upward, the true return was likely even worse. In retrospect, hedge funds delivered similar exposure with worse outcomes than a simple stock/cash mix.
Earlier, hedge funds generated more benefit relative to stocks – from 1993 to 2003 the hedge fund index returned 11.1% per year when the risk-equivalent US equity return was 8.3%. Perhaps hedge fund assets have since escalated much faster than the supply of investment “mistakes” to exploit.
Not “Absolute Return”
Another term often used for hedge funds is “absolute return,” implying positive returns in any environment. However, because hedge funds have a high correlation to the stock market, they typically lose money at the same time that the market does. The chart above shows the four largest drawdowns of the hedge fund index over the past 30 years — each coinciding with major stock market selloffs. The 1998 decline included the collapse of Long-Term Capital Management.
Enormous Fees
On average, hedge fund managers have skill. The problem is that more than all of the benefit of that skill ends up with the fund managers, leaving a losing proposition for clients. From 2010–2023, the hedge fund index returned 4.1% per year. A typical fee structure (1.5% management + 15% performance) means a gross return of 6.6% was required to net 4.1% after fees — nearly 40% of gains going to the manager. The result: investors underperform a simple stock allocation at equivalent risk.
The incentive structure also distorts behavior — small funds are rewarded for risky bets that might pay off, while large funds are rewarded for caution that preserves lucrative management fees. This “risk compression” over time has led to falling returns for hedge fund clients.
Not Transparent
Because hedge funds are exempt from the 40 Act, they disclose far less information. Holdings reports are delayed and incomplete, and investment strategies can shift without notice. This lack of transparency limits an investor’s ability to manage their overall portfolio risk effectively.
Liquidity Risk
Investors in hedge funds who change their mind often have to wait months to withdraw capital — usually three months to a year. Managers may also suspend redemptions. During the 2008–09 financial crisis, many investors were unable to withdraw their money at all.
Tax Inefficient
Hedge funds are particularly poor for taxable investors. Their high turnover generates mostly short-term capital gains — taxed at up to 37% federally and 13.3% in California. Investors also lack visibility into these obligations, often receiving K-1 forms too late to plan properly.
Who Should Invest in Hedge Funds?
Only investors who can identify the best managers in advance. The performance gap between top and median hedge funds exceeds 7.5% per year.[5] Large, institutional investors (e.g., university endowments) have the staff and access to conduct deep due diligence — meeting managers, analyzing strategies, and evaluating operations before investing. Individual investors lack such resources and are unlikely to select the winners consistently.
Summary
David Swensen, Yale’s legendary CIO, wrote in Unconventional Success[6] that individuals should not try to emulate institutional hedge fund strategies. His guidance: focus on diversified, low-cost portfolios of liquid asset classes. We agree. For most individual investors, hedge funds have been a long-term disappointment, and avoiding them entirely is often the best decision.
Disclaimer
The information and opinions contained in this article are for informational purposes only and do not constitute investment advice. Atlas Capital Advisors, Inc. does not guarantee the accuracy, completeness, or timeliness of this information and accepts no liability for any loss arising from its use. This material is not an offer or solicitation to buy or sell any security or investment product. Past performance is not indicative of future results. Investments are subject to risk, including the potential loss of principal.
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