How do I invest in hedge funds?

February. 23,2021
How do I invest in hedge funds?

In fact, hedge funds and private equity are the two largest categories of alternative investments, respectively, and the two industries are comparable in size.In the portfolios of institutional investors in developed countries, the allocation of hedge funds is mostly between 15-30%, while PE and VC allocations are mostly around 5-20%.

Why do hedge funds have such a high proportion of allocation in their portfolios? 

1) Increase returns without sacrificing too much liquidity.PE and VC returns are high, but the money is locked up for 10 years. In contrast, most hedge funds can be redeemed quarterly and are much more flexible. This also provides a tool for investors to tactically allocate assets and rebalance their portfolios.

2) Get Alpha.As an alternative investment, the hedge fund industry has a very significant return differential, significantly higher than traditional long-only stock or bond funds.Many hedge funds only have 0.1-0.5 beta, but still outperform the market over the long term, thanks to manager skill.We all know that the core purpose of asset allocation is to obtain diversified sources of return, and over the long term, traditional mutual funds provide most of the beta, the benefit of hedge funds is that they can provide Alpha.

3) Reduce downside risk. As the name implies, most hedge funds hedge out some of their market risk or reduce their net position by going short. In fact, after decades of constant evolution, most hedge funds today aren't always looking for high returns, but instead place more emphasis on low volatility, low downside risk, and low correlation to the market.

So how do you pick a hedge fund? 

Hedge funds with different strategies tend to have different evaluation criteria, but there are still a few commonalities to consider:

1) The return cycle is critical.

A natural tendency for investors when evaluating hedge fund performance is to focus on recent performance. If a fund is up 30% in each of the last two years, it's natural for investors to plant grass. However, as a footnote in most fund offering materials states, "Past Performance is not Indicative of Future Returns". In particular, recent past performance, such as over the past 12-24 months, is often negatively correlated with future performance.

Why is there so little continuity in hedge fund performance?

While there is no perfect explanation, a number of points may be fundamental:

a. Hedge funds invest mostly in the secondary market and thus follow the principle of median security price reversion by and large. In other words, good performance tends to mean that market valuations have reached their highs, and in a relatively efficient market, the trend tends to be back down.

If an equity hedge fund has returned 30% per year for the past 3 years, its long position has likely gone sky high P/E and is faltering.

b. Human nature. People will always inevitably attribute success to their own subjective abilities rather than to specific external circumstances. But over the longer timeline, most investors are just pigs in the wind. Too much confidence, excessive bonuses, and high management fees for droughts and floods can all be traps for success.

c. Barriers cannot be accumulated. In the primary market, investment institutions form and continually raise barriers through brand advantages, relationship network advantages, and information advantages. Retailers or small institutions will never be able to compete with Blackstone, KKR, Sequoia, Benchmark and other big players. But in the secondary market, there is no barrier to investment. Both hedge fund managers and ordinary people can buy Facebook stock, and they all look at the company's earnings report the same. Without a barrier to entry, it's difficult to create a sustainable barrier to performance, and the continuity of performance is naturally lower.

Therefore, when choosing a hedge fund, it may be worthwhile to pick funds that have an outstanding long-term track record, but whose short-term performance is in the doldrums for reasons not attributable to human error.

2) Focus on the cost effectiveness of risk and return.

Precisely because hedge funds are more liquid, it is important to pay particular attention to volatility risk, as the latter is highly susceptible to behavioral biases that are difficult to avoid, even for experienced investors.

The lower the volatility of a hedge fund, the lower the probability that an investor will make a "mistake". Therefore, when evaluating hedge funds, it is not enough to just look at returns, you must also pay attention to indicators such as volatility and maximum withdrawals. Sharpe ratio, or the return per unit of risk, is commonly used in the industry to measure the cost effectiveness of a fund's risk and return.

3) Look for differentiation.

After decades of development, hedge funds are a highly sophisticated asset class in developed markets. The huge amount of capital, fierce competition and the inevitable groupthink in the industry have led many funds to face the problem of "crowded trades", i.e. homogeneous positions and severely reduced trading margins.

For example, in the past few years, Valeant's acquisition of Allergan and Comcast's acquisition of Time Warner are the kinds of M&A arbitrage transactions that appear in a large number of hedge fund portfolios. The original arbitrage margins have narrowed dramatically due to the same expectations of investors, and this small profit is even more than offset by the potential losses from failed deals.

In the field of alternative investments, there is often a "small fund premium" phenomenon, i.e., the phenomenon of small fund excess returns. To a large extent, this is also because small funds tend to adopt a more focused and segmented investment strategy, which differentiates them from the mainstream market.

Specifically, there are many ways to differentiate:

1) Industry focus, for example, there are many hedge funds in Europe and the United States that focus on the technology or healthcare industry, and hedge funds that specialize in investing in property-backed securities.

2) Technological advantages, such as algorithms that some funds that take quantitative models have polished for years through data scientists.

3) Research ability, for example, some funds that do macro strategy obtain insights on macro economy, fiscal and monetary policy through close relationship with politics and media.

4) Process optimization, risk management, etc.