Presented by Bisdorf Palmer, LLC

WHAT ARE HEDGE FUNDS?

Hedge funds are actively managed pools of capital that can employ a wide variety of investment strategies spanning traditional and nontraditional assets. Many of these strategies use leverage (debt) to try to generate above-average returns. Although these funds have historically been private, liquid structures (e.g., mutual funds and ETFs) have emerged, providing flexibility for investors seeking access to hedge fund strategies.

Hedge fund investments, traditionally targeted to wealthy clients, are often considered a higher-risk alternative investment choice. Investing usually requires a high net worth because of the significant capital requirements involved in private transactions and their illiquid structures. Liquid alternatives have slightly changed this narrative, but the perception that these products are catered to more sophisticated investors still rings true, regardless of liquidity.

WHY INVEST IN HEDGE FUNDS?

Investors may choose to invest in hedge funds to help:

1. Diversify a portfolio. Asset allocation—the act of distributing assets among different asset classes (e.g., stocks, bonds, and cash equivalents)—is a main tenet of modern portfolio theory. By investing in a diversified portfolio of assets with historically low correlations (i.e., they were less likely to perform similarly through various market cycles), an investor may be able construct a portfolio that generates higher risk-adjusted returns. In other words, through diversification, an investor may be able to generate a certain level of returns with lower portfolio volatility. Of course, diversification doesn’t assure a profit or protect against loss during a declining market.

2. Realize uncorrelated and differentiated sources of return. Hedge funds give investors the opportunity to access numerous avenues of return by going long and short with a number of traditional and nontraditional assets globally. This diversified approach allows hedge funds to be exposed to different asset classes that otherwise could not be accessed through traditional investment managers, potentially leading to uncorrelated and complementary sources of return. By going long and short across a number of markets, hedge fund managers have access to a tool kit unique to these strategies, which differentiates them from traditional managers.

3. Realize a lowered volatility profile. Because hedge fund managers can pull multiple levers and employ various investment strategies, a lowered volatility profile is often created. Hedge funds will seek a lowered volatility profile by achieving positive levels of asymmetry in relation to public markets, which seeks to increase the probability for upside.

Considerations When Investing in Hedge Funds

Hedge funds can come in many forms, making them dynamic and accessible to a variety of investor profiles. Below, we explain the difference between liquid and nonliquid hedge funds, along with different strategy types commonly found in the asset class.

• Liquid alternatives/hedge funds. At their core, liquid alternative investments aim to bring hedge fund or hedge fund–like strategies to retail investors at a fraction of the cost and without the illiquidity of traditional alternative funds. More specifically, liquid alternatives refer to daily liquid, open-end funds, such as mutual funds and ETFs, which invest across alternative investment strategies. These funds are designed to bring diversity to a portfolio, minimize volatility, and dampen drawdowns in comparison with traditional asset classes. To achieve this low correlation to traditional markets, liquid alternative strategies may use complex investing strategies, such as investing in options, futures contracts, and derivatives to go long and short with a variety of asset classes, including stocks, bonds, and currencies. These strategies may result in higher costs and risks than traditionally managed funds.
• Private hedge funds (nonliquid): Hedge funds generally include limited partners (investors) and general partners (fund managers). General partners are generally compensated with a management fee (usually a percentage of the underlying fund NAV) and an incentive fee (usually a percentage of profits in excess of prior losses and net of management fees). As private entities, these funds aren’t generally subject to public reporting requirements. Liquidity of these products is limited and can be subject to lockups of investor capital. Private hedge funds typically have quarterly redemption schedules but can also offer monthly, semiannual, or annual liquidity.

Defining Hedge Funds

Hedge funds have a variety of uses and can be catered to a number of investment objectives. Holistically, hedge fund strategies can be divided into diversifiers or enhancers for a portfolio.

We can define diversifiers as alternative strategy funds that provide access to alternative betas and enhancers as alternative strategy funds that can potentially provide more alpha. Beta refers to the risk that investors get paid to take (e.g., equity risk or interest rate risk). Alpha is the additional potential return that results from manager skill, where no additional risk is taken to achieve the return. Ideally, a portfolio should have exposure to different betas and sources of alpha (e.g., different managers and different investment styles).

Below are descriptions of some of what are believed to be defining categories in the alternative space, along with whether each type is considered a diversifier or an enhancer. Keep in mind that funds in the same subcategory can operate very differently and that each alternative strategy comes with unique risk. It’s important, therefore, to understand that hedge fund investments aren’t for everyone. Extensive due diligence should be conducted on each fund, and investors must be aware of the risks.

Common Hedge Fund Strategies

• Long/short equity (enhancer): Long/short portfolios hold sizable stakes in long and short positions in equities and related derivatives. Some funds that fall into this category will shift their exposure to long and short positions depending on their macro outlook or the opportunities they uncover through bottom-up research. Some funds simply hedge long stock positions through ETFs or derivatives.
• Managed futures/systematic trend (diversifier): These funds primarily trade liquid global futures, options, swaps, and foreign exchange contracts, both listed and over the counter. A majority of these funds adhere to trend-following, price-momentum strategies. Other strategies included are systematic mean reversion, discretionary global macro strategies, commodity index tracking, and other futures strategies. These funds obtain exposure primarily through derivatives; holdings are largely cash instruments.
• Multistrategy (diversifier): Multistrategy portfolios offer investors exposure to two or more alternative investment strategies, as defined by Morningstar’s alternative category classifications, through a single manager or multimanager approach. The category includes funds with static allocations to alternative strategies, as well as those that tactically adjust their exposure to different alternative strategies and asset classes. Multistrategy funds typically aim to have low-to-modest sensitivity to traditional market indices, though that may not be the case for strategies with lower alternative allocations.
• Equity market neutral (diversifier): Equity market–neutral funds are a subset of equity long/short funds. Whereas equity long/short funds can adjust their net exposure to the stock market based on the sizes of their long and short baskets, an equity market–neutral fund attempts to maintain a net exposure of zero or close to zero at all times. In other words, it doesn’t matter whether the stock market goes up or down on any given day because the long basket in the fund is the same size as the short basket. What matters is that the long basket outperforms the short basket—that’s the only way an equity market–neutral manager makes money.
• Event driven (diversifier): Event-driven strategies attempt to profit when security prices change in response to certain corporate actions, such as bankruptcies, mergers, acquisitions, emergence from bankruptcy, shifts in corporate strategy, and other atypical events. Activist shareholder and distressed investment strategies also fall into this category. These portfolios typically focus on equity securities but can invest across the capital structure. They typically have low-to-moderate equity market sensitivity because company-specific developments tend to drive security prices.
• Relative value arbitrage (diversifier): Relative value strategies seek pricing discrepancies between pairs or combinations of securities, regardless of asset class. They often employ one or a combination of debt, equity, and convertible arbitrage strategies, among others. They can use significant leverage and typically seek to profit from the convergence of values between securities. Funds in this category typically have low beta exposures to major market indices due to their offsetting long and short exposures.

Risks Associated with Hedge Funds

• Limited liquidity: Hedge funds in limited partnership (LP) structures don’t offer liquidity, which many investors are accustomed to in a mutual fund structure. Redemptions are offered to investors at the discretion of the manager and can even be suspended for periods of time, thus locking up investor money. The lack of liquidity risk is a prevalent theme among most private investment vehicles.
• Lack of transparency: Hedge fund managers aren’t subject to the same regulatory oversight and requirements that public money managers face. This creates a lack of transparency for investors because valuation techniques, underlying portfolio holdings, and leverage usage can be opaque.
• Leveraged positions: Hedge funds can incorporate large amounts of leverage with no restrictions when in a private LP structure. Although using leverage can amplify returns, it can also significantly increase losses because some funds can have gross exposures to the market that exceed 500 percent.
• Manager risk: There is a level of manager risk associated with hedge fund investments. Hedge funds are predicated on active portfolio management—the element of added alpha in these strategies is often driven by portfolio managers because they are, in most strategies, making all discretionary investment decisions. Due to this, it’s important to understand the strategies and be comfortable with a portfolio manager’s style and investment thesis before committing to a particular hedge fund because positive returns aren’t guaranteed.
• Market risk: Investment growth is not guaranteed for hedge funds. These investments can become highly speculative and can create large losses to investment principal. A level of correlation to public market forces can also affect hedge funds.
• Potential for higher fees: Hedge funds in limited partnership (LP) structures employ a fee structure commonly known as “2 and 20”. This consists of a 2 percent management fee which is applied to the total assets under management. Along with this management fee is a 20 percent performance fee on the profits the fund generates. This performance fee is only charged if the performance of the fund is beyond a minimum threshold or watermark—if performance is poor and does not meet the minimum threshold, the performance fee is not applied and only the management fee will be assessed to the investor.
• Complicated tax structure: Hedge funds are taxed differently than traditional investments because they receive Schedule K-1 forms as opposed to 1099 forms for traditional mutual funds or stocks. Since hedge funds are in limited partnership structures and qualify as pass-through entities, they can pass their tax lability to their investors, escaping double taxation. A K-1 breaks down a limited partner’s share of the fund’s profits or losses, which they must then report on their individual tax return.

Sources: Morningstar Global Category™ Classifications

Disclosure: Hedge funds are speculative and not suitable for all investors. The risks include, but are not limited to, the following: the funds may be leveraged; investors could lose all or a substantial amount of their investment; higher fees and expenses may be charged, which may increase the risk that returns are reduced; performance can be volatile; the funds are illiquid and there may be restrictions on transferring fund investments; and there are other specific risks related to particular fund’s investment strategies.

Investors must meet specific suitability standards before investing. Investments are subject to risk, including the loss of principal. Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, utilizing complex financial derivatives, adverse market forces, regulatory and tax code changes, and illiquidity. Past performance is not indicative of future results. There is no assurance that the investment objective of any investment will be attained.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. You should consult a tax preparer, professional tax advisor, and/or a lawyer regarding your individual situation.

Please consider the investment objectives, risks, charges and expenses carefully before investing. The prospectus, which contains this and other information about the fund, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Authored by the Investment Research team at Commonwealth Financial Network®.

© 2023 Commonwealth Financial Network®.