Long-only investment vehicles such as mutual funds, exchange-traded funds (ETFs), and separately managed accounts (SMA) are useful structures in a diversified portfolio. In a market environment conducive to “long-and-strong” or “set-it-and-forget-it” investment approaches – like the bull market following the Global Financial Crisis (GFC) – these traditional vehicles are likely to provide competitive returns.
However, over the next 10 – 15 years, many capital market assumptions are projecting equity returns to be between 5% and 6%, well below historical averages, and the correlation between equity and fixed income returns are expected to increase.1 Amid this uncertainty, fully invested, long-only investment mandates of traditional structures may be limited, and meeting investor return expectations will be difficult to achieve.
Capital market assumptions are forecasting lower returns
A robust toolkit provides more ways to win
In contrast, hedge funds offer broad diversification across multiple asset classes, styles of investment, sectors, regions, and risk-return profiles. They can go long and short, be fully invested, or fully hedged. As volatility rises and market opportunities shift, this dynamism can add significant value in client portfolios.
Over longer periods, the ability to tactically deploy capital and manage risk is a huge advantage over most long-only approaches. While the absolute return in different hedge fund strategies may be higher or lower than traditional assets, the path to success in achieving client goals is likely to be smoother through the avoidance of steep losses and excessive downside volatility. In short, hedge funds have more ways to win when compared with traditional long-only managers.
Complex investments are characterized by higher fees and less liquidity
However, this greater flexibility comes with a comparative cost. Hedge funds charge both management and performance fees; 20% of profits is the norm. They can also have lock ups and limited liquidity. Some funds require that capital be invested for a minimum of 12 months, while others utilize a “soft lock,” an option for investors to redeem during the lock-up period in exchange for an early withdrawal fee. Also, most funds do not provide position-level transparency, aside from required public filings.
By comparison, ETFs, mutual funds and SMAs charge a management fee, which varies but is significantly lower than their hedge fund counterparts; offer daily liquidity; and provide greater transparency of investment holdings.
Hedge funds offer improved risk-return potential amid uncertainty
The bull-market following the GFC was an ideal environment for most long-only structures. Stocks soared to record highs, and bonds provided income, stability, and a counterbalance to occasional equity market shocks. However, as return expectations have declined and uncertainty has increased, the value of hedge fund exposure – and the meaningful diversification it may provide – is at its highest. While this asset class may not be suitable for all investors, it can be a valuable addition to a well-diversified portfolio.
(1) Source: Based on Capital Market Assumptions from Blackrock, JP Morgan, BNY, UBS and Morgan Stanley. Updated as of June 2020.
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