Invest in Hedge Funds? Probably Not!

Key Points

• Hedge funds are typically glorified among investors as the “movers and shakers of Wall Street”- however there are some key risks.

• One is that hedge funds are effectively a “black box” with broad mandates, tons of leverage and the ability to win or lose a ton of money.

• They are typically short term trading strategies that can do well in volatile markets but over time, long only investors typically win.

• In addition, access to the best hedge funds is extremely limited and costly to do so. High fees and high minimums make this impossible for most. 

Billions is A Great Show But Hedge Funds Are Not Always Great

Whether you are a fan of the Showtime series “Billions” or not, you have probably heard of the almighty “hedge fund”. Trying to gain exposure to a hedge fund should be very strategic and you might find that hedge funds really do not always deserve the praise granted to them. 

Let us dive into this a bit more and explain again why equity growth over the long-term is the most proven investment strategy and provide you with a few more details regarding hedge funds in general.

What is a Hedge Fund? Basically they are Investors(Traders) addicted to HIGH Risk!

A hedge fund can aggressively invest in any manner it seems suitable with the sole purpose of achieving absolute return regardless of market conditions. The concept of a fund mandate is widely null and void for most hedge funds as they will invest across all financial products with various strategies. 

Investing over the long-term meaning your strategy is to buy and hold should be at the forefront of any true investor. 

Hedge funds will do this but also deploy what is called a sell short strategy which is what they are most notorious for and entails betting against the market or an individual stock from appreciating in price. 

Remember the GameStop and AMC Drama?

This one really took a hit against some high profile hedge funds who were shorting these names. When it comes to GameStop and AMC, let us make sure you are taking a look at Why A Positive Business Outlook is important and how it ties into Equity Valuation. 

At Genvest, we personally do not believe in damaging a company through concentrated short sales to make a profit, but all in all there was a reason why those names got shorted and sometimes the short position gets squeezed(market moves against you and goes up). 

You do not want to find yourself in this tough spot so stick to what works. Cough Cough, play the long game with quality businesses who are leaders in their respective industries.

This Short Selling Sounds Risky? 

It most certainly can be because the market historically appreciates in value and hedge funds are willing to bet against it with borrowed shares from the broker they do not own. 

The idea is to sell, watch the price decrease, and profit on the difference upon buying the shares back and returning them to the broker. 

This is almost like taking a bull head on if you decided to go running with them in Spain and is not a strategy wise investors should look to take. 

For the record, short selling a stock is very expensive and can do some serious damage to your portfolio if the market moves against the position. 

Didn’t you also say Hedge Funds will take a Buy and Hold, Long Strategy? 

Yes, and while this is true it is often done with borrowed cash from the broker which in most cases can lead to the fund being highly leveraged. Think about it like this, you decided to borrow money from the broker to buy shares with; so the broker is going to require you to have collateral in place just like the bank does with your home mortgage aka your house. 

The details of how this works are more complicated but you kind of get the gist of it! Just like betting against the market is high risk, purchasing securities with borrowed cash is also classified as high risk. 

Short selling and buying stocks with borrowed cash is referred to as margin trading by professionals in the industry.

You are not able to achieve High Returns without High Risk right?

This is true to a certain degree but calculated risk and sticking true to conventional wisdom should be at the forefront of one’s mind when making investment decisions. 

In 2019, hedge funds returned only 6.96% on average compared to the S&P 500 at 30.43%. See why Genvest calls it The Mighty S&P.  

While hedge funds may have had higher returns during some years and a few have stood the test of time with very impressive results, they by and large have not outperformed the broader market on a year by year basis. Check out this chart further capturing hedge fund returns vs. the S&P.

GenVest QuickTake

Outperforming standard benchmarks such as the S&P 500 is already a tough task for mutual fund managers, so why put your money into a hedge fund that has inconsistent returns when you are looking to build wealth over the long-term. 

Do not fall for the risky, quick, trade schemes hedge funds really are at the end of the day because investing in equity over the long run is a proven method, trading on speculation in the short-term is not. 

This is not to say investors should disregard hedge funds entirely or a fund that will mirror itself in a similar manner to a hedge fund. The market does show volatility and it doesn’t hurt to have some exposure to shorts in the portfolio for downside protection.

Over the long-term being more heavily allocated to quality growth companies will reward investors with superior returns. Buy and Hold For the Win!

Trying to have your portfolio mirror a hedge fund allows the broker to have control over your portfolio by agreement. Do not give them this and stay in control of your investments by looking to hold great companies with your personal cash.