In Defense of Hedge Funds…

Photo credit: Sean Davis

Hedge funds don’t get a lot of love these days. They’ve underperformed for years, and their fees — the standard is 2% of assets and 20% of profits — make them pariahs in the age of indexing and low-cost robo advisors.

Hey, I get it. The high fees and lousy performance of competing hedge funds was a major reason that I started a liquid alternative robo advisor with my partner, Dr. Phillip Guerra. We run a suite of risk parity portfolios that hold their own against comparable hedge funds… and we do it at a fraction of their fees.

Yet let’s not throw out the baby with the bathwater. While many — perhaps most — hedge funds add no real value and certainly don’t justify their fees, there are plenty of hedge funds that absolutely do add value and deserve every last cent. But how do you separate the wheat from the chaff?

Ask yourself the following questions:

Does the fund do something unique that realistically cannot be replicated in a cheaper and more transparent vehicle, such as an ETF, mutual fund or managed account?

Really dig deep here. If the fund is a long-only large cap fund, you should be skeptical as to whether the hedge fund structure is necessary. If the fund employs sophisticated hedges that would be hard to implement in a smaller managed account, then the hedge fund structure is probably justified.

Does the fund deal in illiquid securities that would justify the lack of liquidity of the fund itself?

Years ago, a hedge fund in the DFW area made a fortune buying idled planes from the major airlines. Needless to say, that sort of thing would be impossible to replicate in a mutual fund, ETF or managed account. It’s virtually impossible (or at least impractical) to securitize an airplane. On a similar note, in the past I have placed accredited investor clients in a fund that finances medical accounts receivable that might take two years or more to pay off. It’s hard to see a strategy like that working in a mutual fund that promises daily liquidity.

Defaulted Argentine bonds… large macro bets with credit default swaps… I could go on all day giving examples of illiquid opportunities that wouldn’t make sense outside of a hedge fund. But an outsized bet on Apple or Valeant Pharmaceuticals? Not so much. You can do that on your own in a discount online brokerage account without having to pay the 2 and 20 to the manager.

Does the fund have a strategy that would be fundamentally undermined by investor redemptions?

Think about corporate raiders like Daniel Loeb or Carl Icahn. These guys are known for amassing massive stakes in companies and then using their clout to force change, including booting out management that is underperforming. That only works if you have a stable pool of capital. Imagine Loeb attempting to take over a company and then having to back away with his tail tucked between his legs because he had a wave of shareholder redemptions.

When your advisor pitches you a hedge fund, you shouldn’t necessarily recoil in horror. I regularly incorporate hedge funds into the portfolios of my accredited investor clients when they fill a specific niche I’m trying to fill. And to date (knock on wood), I have yet to have a major disappointment on this front. I’ve lost plenty of money for myself and clients in low-cost ETFs and mutual funds, though I’ve never lost money (again, knock on wood) investing in a good alternative manager or hedge fund. I probably will at some point. You know the drill, past performance is no guarantee of future results. But I can credibly say that it hasn’t happened yet.

Before you invest a single red cent in a hedge fund, ask yourself the questions above. Hedge funds are certainly not for everyone, but if utilized correctly they can reduce portfolio volatility without sacrificing returns.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.