Four Questions to Consider BEFORE Investing in Hedge Funds

In a world of low expected returns across most asset classes, it can be tempting for investors to search for ways to increase their expected returns by turning towards alternative investment strategies such as hedge funds.  The label “hedge funds” has become a generic description of the very broad universe of diverse strategies that tend to relax the typical portfolio constraints that are placed upon long-only investment managers.  The increased flexibility of hedge funds has led many to believe that they can provide better risk-adjusted returns over time, with less volatility than more traditional investment portfolios.  While there are many successful hedge funds, as a broad group, they are no investment panacea.  Investors who are tempted to invest in hedge funds should be aware that the potential for superior risk-adjusted returns does not mean that this promise, ultimately, will be realized.  There are a number of hurdles that need to be taken into consideration and questions that should be asked before committing investment dollars to the nebulous universe of hedge funds.  Here are a few considerations that should be considered:

1.  Is the fund’s strategy really different? Hedge funds utilize the typical array of asset classes as a means to construct their strategies.  While many hedge funds promise low correlations to traditional asset classes, and, therefore, claim to offer a unique diversifying addition to a traditional portfolio, in reality, many do not deliver what they promise.  Correlations and betas for most hedge funds tend to show a high consistency with the returns of the broad market of their chosen investments.  If you are already invested and have exposure to equity beta, you should be sure that your potential hedge fund investment is not just very expensive beta in drag.       More