Hedge funds are an interesting study when you consider that not long ago they were so obscure that when I told people what I did, some of them asked me if I was in the landscaping business. But that didn’t last long. In the early aughts, they became a celebrated investment vehicle among the press and throughout popular culture. And then, suddenly, the mood shifted. Since 2008, they have been vilified and blamed for hastening the mortgage crisis. It is no wonder many consumers interested in investing in the vehicles are left scratching their heads.
Misperceptions about what hedge funds do need to be set straight. Individuals won’t be able to make educated investment decisions about them unless they understand what they are—and are not. While it’s impossible to address every myth or misunderstanding about hedge funds, the most common are debunked below.
Myth #1: They are risky.
Sometimes, sure. But there are two important points to understand in response to this myth with respect to hedge funds and most other alternative investment vehicles: 1) they are typically managed to minimize the market risk associated with being long stocks and bonds, and 2) the portfolio manager is usually invested in their own funds and, as a consequence, tends to be a zealot about adhering to the first point, above.
Myth #2: They all use lots of leverage (borrowed money).
There are many different hedge fund strategies and the leverage employed ranges from none at all to heavily-levered. It is very difficult to generalize about hedge fund portfolio construction. This is why it is critical to understand how a manager manages money and what their risk tolerance is before investing. But most funds use modest amounts of leverage if they use any, and it typically comes from the short portfolio and exists to generate returns and act as a hedge.
This myth seems to have its roots in the blow-up of Long-Term Capital Management (LTCM), a hedge fund that suffered a major decline in 1998. Unfortunately, this is an example of a fund that used jaw-dropping leverage. Blow-ups like LTCM make the news and capture the public’s attention because they are infrequent and almost always involve large doses of borrowed money.
Myth #3: They invest in illiquid investments (timberland, oil wells, etc.).
Most hedge fund managers actually prefer liquid investments in liquid markets. The illiquid investments are typically found in private equity and venture capital funds. While it is true that most hedge funds maintain the flexibility to invest in any investment that meets the criteria set out by the portfolio manager, one will find that illiquid investments are the exception and not the rule. Liquidity is all relative, of course. Some strategies are inherently less liquid than others. Funds that invest in whole loans from banks, for example, have a portfolio of investments (in this example, loans) that are far less liquid than an equity long-short fund that invests in U.S. large cap stocks.
Myth #4: You have to be rich to invest.
While it is true that to be an investor in any sort of limited partnership (which is typically how hedge, private equity and venture capital funds are structured) one needs to be an ‘accredited investor.’ Today however, ‘alternative’ strategies are increasingly being offered in more liquid and investor-friendly structures such as mutual funds and closed-end funds. (Full disclosure: I manage a fund for Thesis Fund Management called The Flexible Fund, a mutual fund that employs alternative, hedge-fund style, strategies.)
Myth #5: They always go up.
No investment only goes up. Like any other investment, hedge funds can have periods of good performance and periods of bad performance. Where the typical hedge fund differs from the typical long-only fund is in the hedging. Most hedge funds short securities instead of only owning, or being long, securities. The shorts serve to mute market volatility, protect against a big market decline and should generate excess return if the manager picks good shorts. The hedge fund manager also seeks to manage risk by actively managing position sizes and the portfolio’s exposure to the market.
These critical differences in approach to managing money will typically mean that over a market cycle, a long-short strategy has the potential to outperform the market and its long-only peers.
Don’t worry. I don’t think the myths will last. As hedge funds become more transparent and familiar, I expect these misperceptions to become about as quaint and outmoded as the idea of, say, living without a computer.