Why Professional Investors Invest in Hedge Funds

The following post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga.

Why Pros Invest in Hedge Funds

Let’s begin with the number one challenge any hedge fund investor has, and that is finding the good ones. While we’ll review why professional investors have invested their clients' money in hedge funds for years, a critical part of that process is finding quality funds. CARL provides funds that have received full institutional-level due diligence and also the funds have passed our bar for quality. We want you to be assured whatever fund you’re viewing on CARL’s platform, it’s at a reasonable standard of performance.

So hold that bar of reasonable performance in your back pocket as we walk our pro investors hedge fund process. It will be important later.

The Pros Old Ways

Institutions and the uber-wealthy have been investing in hedge funds for many years. In the beginning hedge funds did what their name implies, hege the market. As time went on, however, proprietary “sophisticated” funds, run by fund managers without disclosing all the details of their strategy (not required per regulation) simply all became known as hedge funds. Sophisticated investments groups deploying techniques to beat the market usually with less risk than market indices.

Then, institutions or the uber-wealthy professional money managers interested in hedge funds have to go find groups with strategies they may be interested in, discuss the strategy, perform due diligence on the fund to make sure it’s on the up-and-up, invest usually at least $1M, and lock those funds with the strategy for usually at least 1 year. Sometimes it’s many millions more dollars and several more years being locked.

So why? Why go through all the bother? 

Grow - Do NOT Lose Capital

Institutions and the uber-wealthy generally hire professional investment managers to grow their money. Note the word “grow”. These managers are hired for growth, and no one wants to report to a board of directors that they lost any significant capital. That generally means they’ll also lose their job! This means contrary to the stereotypes, professional investors aren’t trying to find hedge funds that produce outrageous gains at the cost of higher risks than standard market indices. No, no, no. That is very bad for them.

Professional investors are looking for lower levels of risk, a better than index risk profile, with a reasonably assured return. Yes, you read that right, just a reasonably assured return. That might literally be 4-6%, and only 6% of professional investors sought returns above 10% according to Preqin 2014 research. It is more important to the pros to lift a portfolio by bringing down volatility than push high returns at unreasonable risk.

The why then becomes simple, they can achieve higher assurance of growth with less risk by using hedge funds in their portfolios.

Now, some allocate 20% of their portfolios to hedge funds and others 10%, while most pros managing multi-million dollar portfolios do use them.

The Great Diversification

Ever had 100 million bucks you had to diversify? If you’re a fairly average accredited investor you probably work with a wealth advisor of some kind. They’ve certainly walked you through an old 60/40 portfolio (60% stocks 40% bonds, wait 30 years, you’re a millionaire!). If they’re any good these days they would mention now 10-20% of portfolios are usually allotted to alternative investments, and the aggression level of the alternatives would be determined by how close you are to retirement or the other investing goals of the portfolio. If you’re an average accredited investor, they did not discuss hedge funds with you because you wouldn’t put $1 million of your money in one!

If there’s 30, 50 or 100 million to diversify, you can imagine that there’s a bit more to talk about then just the old three categories in general. Now, you’re supposed to weather the “just hold for years” long term view in most investment conversations unless you’re fairly savvy. If you don’t enjoy a market downturn where you lose 20% of your portfolio in a week or month, how do you think the multi-millionaire feels when s/he gets that call from their money manager? Personally, I wouldn’t want to make that call “Hi Shirley, yes we’re in one of the bad downturns, and they’re not too frequent but you’ve lost $10 million dollars.”

Now good money managers will have stop gap risk controls to push to cash before the bottom of a drawdown, while diversification is it’s own downturn minimizer without stalling out to cash. According to a recent article in The Balance, for institutional and pro investors, “Some are still trying to recover losses incurred in the crash of 2008.” Yes, that’s still recovering 13 years later. Sometimes it just gets bad and the hold to recovery is long.

Being uncorrelated, truly diversifying, is what they seek because during downturns they can outperform the market. That generally equates to overall outperforming.

Enter hedge funds. Find the uncorrelated ones and put 10-20% of the portfolio there. Except, they don’t all perform as expected.

Selection Really Matters

This is where that first note on a bar of quality begins to matter. Pros are using hedge funds to get investments with better risk profiles than standard market indices, and use them to weather better in downturns and overall outperform the market. Little wrinkle, many professionals in the last 10 years found the funds underperformed and cut down the amount invested in such funds. Whoa, what? Isn’t this article pro hedge funds?

Well, we know hedge funds. That means we can tell you in full disclosure there are a lot of bad ones. Now, a hedge fund can be a Ponzi scheme kind of bad, that’s just fraud and that’s going to be the absolute worst, while there are other shades of bad. Here are a few that we see regularly:

• Correlated to the market, so no real sophisticated strategy, no diversification protection
• Over leveraged
• Not proper strategy/trading risk controls
• Not proper operational risk controls

Any of the above can lead to lackluster performance, while correlation has been a big one in CARL’s experience. We complete institutional-level due diligence on all our funds, but before a fund even gets to that point they have to pass the basics. We’ve reviewed over 400 funds in the last 18 months, with 12 making the final grade to be on the CARL platform. The biggest reason for rejection is correlation. Many, many hedge funds are just rolling with the market. That’s not going to help diversification, the number one reason most investors use hedge funds! Plus, hedge funds have pretty high fees. Those fees make sense when funds perform.

That’s why a CARL fund must be truly uncorrelated and usually have 15%+ targeted returns with a history to support it (some funds built to replace bonds will have lower yields with low volatility to match, and that makes sense for some investors in bond replacement). Note this doesn’t guarantee fund performance all the time, while it gives that reasonable quality that these funds have historically weathered their own downturns better either in downturn depth, time, or both.

Let Experts Make Your Shortlist

Selection being so critical, this is why reviewing hedge funds from an index or total hedge fund market perspective is a little useless. 10-30% of hedge funds close each year, they don’t have to provide detailed reporting on their strategies, many are market correlated...looking at all hedge funds together will generally not look good

In addition, you may be surprised to find out there are many professional investors who don’t actually know how to properly assess a hedge fund. It’s true, they pay others to perform levels of due diligence and sometimes they know what they’re doing and sometimes not so much. Let’s say you often get what you pay for, and these costs can run $50k upwards of $200k just to assess one or multiple funds. Before CARL it was just tough to find those who have reviewed a lot of funds and have real expertise doing it.

This is why you need a partner who knows how to separate reasonable quality standards from the masses. This is a large part of what CARL does. We do the heavy lifting, allowing our experts to find the true hedge fund experts. Every fund we offer we make sure we would invest in, that it meets or exceeds reasonable hedge fund investing professional standards.

CARL is adding a new hedge fund about every two months, and will grow to about 20-30 hedge funds on our platform. All above our minimum reasonable quality standards.

Invest Like the Pros and Grow Your Money Faster

This is the idea. It doesn’t matter how much money you have, it really doesn’t. The more you truly diversify, find uncorrelated investments, the better you will weather all types of markets. The good news with hedge funds is that you can also usually keep those equities market-level gains, you don’t have to completely trade high quality returns for the lower risk. That’s why the pros use hedge funds, and now you can too. Only you have an additional advantage in CARL’s due diligence process that you can quickly, at your fingertips in the CARL app, get a hedge fund short list vetted to reasonable quality standards. 

Contact us today, and we’re happy to walk you through our funds. There are different types with different portfolio utility, so whatever your portfolio could use we’re confident we’re got a quality hedge fund option for you.

The preceding post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga. Although the piece is not and should not be construed as editorial content, the sponsored content team works to ensure that any and all information contained within is true and accurate to the best of their knowledge and research. This content is for informational purposes only and not intended to be investing advice.