Are hedge funds worth the risk today?

VaselineAugust 14, 2024

0 4 minutes read

Michael Sonnenfeldt, chairman of the “ultra-high net worth” network Tiger 21, said hedge funds were “dead as a door” as his members’ allocation fell to just 2% – down 10 percentage points from 2008 .

But for a wide range of yield-oriented investors, hedge funds are still very much alive and well and a key part of a successful portfolio in this era of stock market valuations.

It’s no surprise that Sonnenfeldt and other market watchers are looking at the trends around hedge funds and calling their final rites. Index funds have crashed since the Great Recession, and asset classes of all types have struggled to recover. Strong performance in the broader stock market will always diminish the appeal of hedge funds, which are more expensive to access and offer less liquidity than index funds.

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But the performance of hedge funds and the withdrawal of a group of savvy centimillionaires from them cannot be evaluated in a vacuum. When the Tiger 21 members had their maximum allocation in hedge funds, the global economy was in freefall. Banks were failing, companies were faltering, and the S&P was falling.

The 8% loss suffered by hedge funds was much smaller than the 39% loss suffered by the S&P. Hedge funds were one of the smartest places to put money in 2008.

Another story today

Today, however, we’re looking at almost the opposite scenario: The stock market has performed remarkably well since the Great Recession, and index funds have benefited from what was essentially a secular bull market — strong, except for some related pandemic. blips.

But today’s market strength should never be taken as a promise for tomorrow. Playing the puck where it’s at is rarely a good investment strategy, and to keep the metaphor going, there are plenty of worrying cracks in our current economic ice surface. In this context, holding hedge fund assets as part of a healthy portfolio is simply smart.

What we are seeing now is an onion economy: looking at the surface of the index, it seems to be working well. But as we peel away the layers, it’s clear that it’s actually only a small sub-category of that index that generates most of the return.

By now, it’s well known that the S&P 500’s remarkable run last year was almost entirely on the back of the Magnificent 7 tech companies. It’s a trend we’re more than likely to see repeated this year as Nvidia ( NVDA ) continues to carve its way through the market, hitting new highs and setting records.

This is all good news for index funds and those invested in them – and points to clear trends about where the market is headed. Artificial intelligence and computer chips will continue to set the world on fire and will apparently usher in new waves of dollars for investors chasing technology-based profits.

Looking beyond the Magnificent 7

But the rest of the market does not rest on such a sure footing. Without the Magnificent 7, the S&P equal weight index is just 4.72%, a significantly less impressive measure of growth. Meanwhile, the small-cap index is up just 0.5% year to date. Without the glimmer of AI to drive it, the index’s performance is just average.

None of this is to say that these are necessarily bad companies, but collectively the signs point to a possible market downturn. When that happens, index funds will suffer; investing in the S&P only works until it doesn’t.

When it isn’t, investors will need and want diversification in their portfolios—diversification that hedge funds are well positioned to provide right now. In general, hedge funds typically benefit from having a lower correlation with the stock market and a lower beta. They allow for more selective strategies than index funds, giving investors more choice whether to pursue an event-based strategy or one that is more market neutral. With the right fund, investors can actually find better performance with less risk.

I know of funds that regularly outperform the S&P 500 by over 3% per year when evaluated over the long term. Other hedge funds are up more than 10% in 2022, when the S&P as a whole is down 19%.

Hedge funds are not without their drawbacks

While access to many of the best-performing hedge funds requires being a skilled buyer investor, for people who can invest, it’s often worth it. These funds have far better long-term results than those generally available in the mass market.

But obviously the active management, research and technology platforms these funds require come with high fees and a minimum one-year lock-in period. And even then, the best-researched and managed funds can still have periods of volatility compared to broader market indices.

But as the 7 less-than-magnificent stocks on the S&P continue to struggle, investors will want a more nuanced approach to stock picking than is available from index and mutual funds. Hedge funds will be a key part of this more selective mindset, one that enables risk management, as the economy is looped into the age of AI.

Hedge funds are not dead, and events in the not-so-distant future could find the investing tigers roaring for them again.

This article was written by and represents the views of our contributing advisor, not the Kiplinger editorial staff. You can check advisor records with help dry or with FINRA.

VaselineAugust 14, 2024

0 4 minutes read

Vaseline

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