Why Are Hedge Funds So Popular Despite Recent Disappointing Returns?

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Is the continued popularity of hedge funds driven by a herd mentality? Reynolds Group, Private Investment Counselors provides six considerations for investing in hedge funds and three critical success factors for managing your hedge funds.

Six Considerations to Address with Your Investment Advisers When Investing in Hedge Funds

1.How have your hedge funds performed relative to your other investments? Specifically, how have your long-term hedge fund returns been vis-a-vis your other asset classes and capital market benchmarks? Do you have an absolute standard for the return you want to generate? How have your hedge funds performed vs. that goal? The answers to these questions are more important than whether the hedge fund industry’s assets under management "AUM" is up or down.

2.Are you fully satisfied with your hedge fund selection process? Manager selection is always important, but the hedge fund environment is particularly complex with limited public information. Additionally, since hedge funds have liquidity constraints, you are not free to terminate an unsatisfactory investment on a moment’s notice. The best information regarding detailed fund-by-fund returns and thorough due diligence about hedge funds is highly proprietary. Most wise investors retain an expert consultant to assist them with manager selection.

3.Has your hedge fund program offered protection for your portfolio in periods of crisis? The years 1987, 2001, 2008 and early 2009 were particularly difficult for investors. Be sure to evaluate the returns of each of your current (or potential) hedge funds to see how well each of them behaved during periods of financial crisis or severe stress.

4.Are your hedge funds equity alternatives or fixed income alternatives? If a fund is to be used as fixed income alternative then it should not be compared to the returns of the S&P 500. You need to have a candid dialogue with your advisers and/or each hedge fund manager to develop a fair and appropriate set of expectations about each fund’s potential investment return and volatility.

5.What role do you want hedge funds to play in terms of managing your portfolio’s volatility? Hedge funds can play a favorable role in reducing volatility. You may be well-advised to accept a reduced return compared to the S&P 500, or other capital markets return, if the hedge funds you invest in can reduce the overall volatility of your portfolio and achieve a predictable return.

6.How much organizational risk can you accept? In building a hedge fund portfolio, you can put hedge funds roughly into three categories:

  • Mega Managers: These are large, multi-billion dollar funds with the capacity to accept significant additional AUM. Their names may appear in the business press with some regularity. They may even be publicly traded companies, or belong to large public financial institutions. These mega funds typically have the least organizational risk. On the other hand, they may not be the most interesting and rewarding funds over the next 10 years – they have already made it big.
  • Institutional Main Stream: These funds are somewhat smaller, and may be highly selective in taking additional investor assets – many are open only with a suitable introduction. They may not be willing to engage in fee-sharing with financial institutions that sponsor hedge fund platforms. These funds tend to avoid the press and are hard to find without expert assistance. While they may have more organizational risk than the mega managers, they are well-established businesses (nonetheless professional due diligence is essential).
  • Emerging Managers: These funds have $50 million – $1.5 billion in AUM and may have the greatest organization risk. Investors typically engage specialized expertise in the emerging funds arena to help them ‘get it right’ (i.e., stay out of trouble). All that said, there can be very rewarding investment opportunities with emerging funds.

Three Critical Success Factors for Investing in Hedge Funds

1.Determine the strategic role for your hedge funds: Wise investors do not embrace hedge funds to follow the herd. Nor do they employ hedge funds to maximize short-term returns. Prudent investors hire hedge fund managers to accomplish an important role in their portfolio in terms of risk/volatility management. Their mission is to achieve favorable long-term returns that are more muted than long-only equities, but attractive nonetheless.

2.Evaluate structural considerations: Informed investors understand the liquidity limitations of their hedge fund portfolios, as well as the fee burdens that hedge funds bear. Furthermore, thoughtful taxable investors explore the after-tax returns from their hedge fund portfolios.

3.Build an effective management team: Prior to embarking upon hedge fund investments, sensible investors are careful to assemble the right professionals and a deeply experienced investment committee to help them to construct and manage a highly successful program.

Questions about investing in hedge funds? Please call 617.945.5157 or email jack(at)rgpic(dot)com. Our complete disclaimer appears here http://bit.ly/1Gnzbwy.

About Us
Reynolds Group, Private Investment Counselors was established in 2010 to help clients manage and resolve the complex investment, asset protection and legacy planning needs that comes with having significant investment resources. John M. (Jack) Reynolds, the firm’s founder, has over 25 years of investment experience growing and protecting financial and non-financial assets for individuals, family offices, endowments and professional services firms in the United States and Europe.

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Jack Reynolds

Lisa Ann Maini
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