From the July 2014 issue of Investment Advisor • Subscribe!

Investors Are Flocking to Hedge Funds Despite ‘Underperformance’

New regulations, global uncertainty and sluggish performance aren't enough to dull investors’ appetites

Why are investors so eager for hedge funds when their performance has been underwhelming? Why are investors so eager for hedge funds when their performance has been underwhelming?

Investors are pouring more money than ever into hedge funds. Reuters found that assets under management totaled more than $2.9 trillion in April, higher than the previous peak just before the financial crisis hit in 2008. This has occurred despite considerable headwinds, including complicated new regulations, global uncertainty and, most remarkably, the fact that hedge fund performance has lagged popular benchmarks for five years in a row, according to Bloomberg. What's going on? A few things.

First, the hedge fund industry has undergone significant changes, starting in 2001 when it was able to avoid the tech wreck, and again in 2008, when on average hedge funds lost less than half as much as equities. Today, avoiding losses trumps bragging rights about double-digit returns. It's no surprise that a recent survey by MainStay Investments of more than 800 high-net-worth investors found that protecting principal was the reason given most often for investing in alternatives, followed by diversification and potential return. A new era has dawned as investors have changed how they view hedge funds and their role in portfolios, commented Preqin, the London-based research firm, in its 2014 report on the global hedge fund industry.

A second factor at work is the move away from tying performance to benchmarks like the S&P 500, an index that is most relevant for a diversified, large-cap, long-only equity manager. Investors are realizing that standard equity indexes may not be useful in measuring hedge fund performance. As Preqin pointed out, hedge funds rely on an increasing number of investment strategies beyond equities. It makes little sense to compare a distressed debt hedge fund coping with the debt of a near-bankrupt company to U.S. stocks. Rather, this hedge fund should be compared to an event-driven or distressed index of hedge funds with similar characteristics.

Third, many baby boomers who exited the stock market in 2009 are looking for returns from non-correlated investments like hedge funds. According to the MainStay survey, 61% of investors in alternatives said they were reallocating from cash and money market accounts, followed by equities and fixed income.

Even the dramatic rise in, and knowledge about, liquid alternatives has contributed to a greater degree of comfort with hedge funds. Hedge fund investing today is far different from what it was 10 years ago, when high risk and high return was the common perception of the asset class. Today, many investors view hedge funds as a potential way to both dampen volatility in their portfolios and provide for better risk-adjusted returns. For a variety of reasons, investors seemingly have a better understanding of what hedge funds can do.

What hasn't been a contributing factor to hedge fund resurgence is advertising. Despite the Jumpstart Our Business Startups (JOBS) Act and the ending of the SEC's ban on “general solicitation” by hedge funds, ads for hedge funds are a non-event. Only 4% of hedge funds say they have registered to market their funds, according to a recent Preqin study. The main objection was the added cost; the second was not wanting to be first. Preqin found that whatever benefits the JOBS Act held out to hedge fund managers were overshadowed by the potential downsides, including increased scrutiny of regulators, the negative perception of marketing and additional costs of advertising. No surprise, then, that Preqin predicted a slow “uptake” of the JOBS Act.

This won't stop assets flowing into hedge funds, about two-thirds of which flow from institutions. Institutional investors have plenty of ways to educate themselves about the potential risks and benefits of hedge funds. They have access to extensive—and expensive—databases, pitches from hedge fund managers themselves and advice from consultants and third-party marketers.

Individual investors, on the other hand, have a much more difficult task assessing hedge funds on their own, a situation that hedge fund industry gadfly Phillip Goldstein says is like forbidding shoppers from window-shopping at Tiffany's. Hedge fund advertisements wouldn't answer all individual investors’ questions, but it would get the transparency ball rolling.

In the meantime, RIAs will continue to do the leg work for their clients. Most HNW individuals say they learn about hedge funds and alternatives from their financial advisors, nearly 60% in MainStay's survey. For the time being, that's not likely to change—regardless of hedge fund performance.

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