Hedge funds employ strategies and trading styles as unique as the objectives guiding the investors they partner with. A recent Preqin report (LINK) underscores the unique nature of each partnership between a fund and institutional investors working to achieve a specific set of goals and objectives. Most often these goals include steady absolute returns that are uncorrelated to equity markets, portfolio diversification and risk management, rather than the simple metric of ‘high returns.’
When measured against the actual objectives set forth by investment partners, hedge funds are performing quite well, with 84 percent of investors indicating funds have ‘met or exceeded’ expectations over the past year. According to Preqin’s Special Report, institutional investors steadily increased their allocation to hedge funds between December 2012 and April 2014, including “maiden” investments and increases to existing allocations. Capital from institutional investors currently accounts for 66% of assets under management in the hedge fund industry today.
These investors partner with hedge funds to achieve specific, unique goals within their investment portfolios. According to the Preqin data, key objectives most frequently cited by investors include: returns that are uncorrelated to equity markets, absolute returns in all markets, dampening portfolio volatility and diversifying total portfolio.
Specifically, a huge majority of investors told Preqin that hedge funds help reduce risk in their portoflios. Ninety-five percent of investors said that their hedge fund portfolios are designed to have less volatility than their equities portfolio. Furthermore, 80% said that removing hedge funds would increase risks in their portfolios.
Focusing on returns, Preqin found that “producing high returns, a perception many outside of the industry believe is the domain of the hedge fund, is a priority for just a small proportion (7%) of the investors that participated in Preqin’s survey.” As shown in the chart below, the absolute returns sought by investors from hedge funds are relatively modest. Two-thirds (67%) of investors indicated they seek annual returns between 4% and 6%.
Another way investors commonly evaluate hedge funds is by assessing their Sharpe Ratio over a number of years. Sharpe Ratio measures performance while taking into account the amount of risk to which the investments are exposed. Comparing a hedge fund or hedge fund index’s Sharpe Ratio to the S&P 500’s Sharpe Ratio is a good way to benchmark performance for hedge funds, and recently, hedge funds have routinely outperformed the S&P 500 when comparing Sharpe Ratios.
Hedge Funds also produce less volatile returns. From 2008-2012: Hedge fund volatility stayed within a range of 4.4% to 15.1%. The volatility of the S&P 500 did not drop below 10% and topped out at over 30%. While the S&P 500 has made steady gains over the past three years, hedge funds still outperform the index over a 15 year time period, which includes the financial crisis.