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Demystifying the global hedge fund industry

A 20-year veteran dispels common myths and misperceptions Canadian investors may have about the hedge fund industry.

January 21, 2025

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Hedge funds (HF) are a surprisingly large asset class, representing US$4.5 trillion in assets under management globally. However, entry has typically been limited to the largest and most sophisticated investors—an exclusion that has inadvertently resulted in widespread misperceptions about hedge funds.

Now, as alternative markets continue to be democratized and more investors have the opportunity to enter the asset class, there is a greater need for education. This report is intended to clarify key details so investors can have the confidence to make informed determinations about their portfolio construction.

Myth #1: Hedge funds are out of favour.

Reality: Hedge funds are actually experiencing a resurgence of interest in institutional portfolios. Data from a multi-year survey of allocators conducted by the Goldman Sachs Capital Introduction Team shows it is the most popular asset class for the first time since 2020. Additionally, the percentage of allocators wanting to increase their exposure to the industry reached the highest levels on record in 2024, a clear signal that interest is expanding rather than receding.

There is, of course, a cyclical nature to flows. Investors who lived through the decade after the Great Financial Crisis witnessed a highly unusual market, where an unprecedented amount of liquidity was pumped into the system via quantitative easing (QE).

Percentage of allocators planning to increase/decrease exposure by asset class

A bar chart showing the percentage of allocators planning to increase / decrease exposure by asset class

Source: Goldman Sachs Capital Introduction Annual Allocator Surveys, 2022-2024. All data as of July 25, 2024 except where otherwise noted. Past performance is not indicative of future results. This material is for discussion purposes only and does not purport to contain a comprehensive analysis of the risks / rewards of any idea or strategy. Industry-wide information in this material may have been extrapolated solely from data, surveys or observations relating to hedge fund activity conducted solely in Goldman Sachs prime brokerage accounts. Information sourced exclusively from the Goldman Sachs client base or observations of the GS Capital Introduction Team may not be representative of the broader global hedge fund industry.

This ‘easy money’ compressed market volatility and led to an incredibly supportive environment for traditional risk assets. As a result, hedge fund managers in the 2010s faced two major headwinds.

  1. There was less need for alternative assets when the global stock market was delivering double-digit returns. (And bonds too were flourishing because every time equities underperformed, the U.S. Federal Reserve responded by slashing interest rates, which in turn caused bond prices to rally.)

  2. On an absolute return basis, performance tends to suffer when there is less volatility on which to trade. Alpha generation (returns above the benchmark) is essentially a function of the manager’s talent multiplied by variance within the opportunity set, and since there was less dispersion when interest rates were low, the payoff was also lower. This means the skill-based part of investment returns—in effect, the bread and butter of the hedge funds industry—was somewhat compressed by the investment environment.

Once interest rates started to rise, however, we saw more normalized volatility in the market and greater rewards for active managers who made the right calls. While this sort of cyclicality is to be expected, economists largely agree that the QE-driven environment was a historical anomaly that led to unconventional market dynamics. As a practical example, consider the payoff from a short position. Weaker and underperforming companies found it much easier to refinance during the Zero Interest Rate Policy (ZIRP) era because when the cost of capital is that low, you can almost always secure more liquidity to keep your company going. In a higher rate environment, those laggards often struggle to find funding and eventually file for bankruptcy. In other words, the return on a correct call would differ enormously from one era to the other.

Market trends post QE (elevated rates, inflation, volatility) → uncorrelated hedge fund returns now more valuable and possible

A hybrid chart showing market trends during and after quantitative easing and why uncorrelated hedge fund returns are now more valuable and possible

Source: BMO Global Asset Management as of June 30, 2024. Equities = MSCI World NR USD. Fixed Income = Barclays Global Agg. Source: MSCI as of June 30, 2024. Source: Barclays as of June 30, 2024. Post-QE begins January 1, 2022. Past correlations are not indicative of future correlations, which may vary.

Now let’s think of an alternate environment: 2022. This was the inverse of QE—equities and bonds were once again moving in lockstep and both generating negative returns on the year.

If your portfolio only contained stocks and bonds, you were getting hit on both sides and probably searching for a diversified return stream. Many of Canada’s Maple Eight pension funds—which collectively pioneered a model that embraced large private markets allocations—did not have to look for alternate sources of alpha. Those that had done a good job selecting high quality hedge funds in their portfolio, generated positive returns in 2022—thereby providing good diversification to stocks and bonds.

Myth #2: Hedge funds are too risky.

Reality: Skill-based strategies found in hedge funds tend to operate at a lower level of risk than broad market indices, such as the S&P 500, MSCI World or U.S. Aggregate Bond. In fact, the reason hedge funds can be found in so many institutional portfolios is not solely for their alpha, but also because they can help to reduce the portfolio’s overall beta (risk relative to the market).

A table showing the low correlation of hedge fund strategies and major broad market indices.

1. Monthly return data source: XIG. As of June 30, 2024.
2. Pairwise correlations are likely to vary with time and index selection.
3. Albourne Partners Limited © Albourne Hedge Fund Returns Series (“HedgeRS”) 2024, https://www-us.albourne.com/. Indices include: 1) S&P GSCI Total Return, 2) S&P 500 Gross Unhedged USD Net, 3) MSCI World Index, Net, 4) Bloomberg Barclays US Agg Unhedged USD, 5) JPM Emerging Markets Bond ETF, 6) Barclays US High Yield Unhedged USD, 7) S&P Global Infrastructure Net Return. 8) HedgeRS EW Directional Global Macro, 9) HedgeRS EW Directional CTA, 10) 60% Fundamental EMN + 40% Quant EMN = [60% * HedgeRS Relative Value Fundamental Equity Market Neutral] + [40% * HedgeRS Relative Value Quant Equity Market Neutral], 11) HedgeRS EW Relative Value Multi-Strategy, 12) HedgeRS EW Relative Value Fixed Income Arbitrage, 13) HedgeRS EW Relative Value Statistical Arbitrage. The index returns used for correlation presented above are net of manager management and incentive fees but exclude XIG GS advisory fees. Other expenses an investor may incur will reduce the net return to the client. Please see Appendix for further explanation of the effect of fees on performance. Past correlations are not indicative of future correlations, which may vary. Diversification does not protect an investor from market risk and does not ensure a profit.

So, where does the association with risk come from? We believe there are four primary drivers of risk with respect to hedge funds:

  • Leverage: While it is true that hedge funds use leverage to increase returns, it is typically done in a risk-managed way. For example, if a portfolio is equally long and short on equities, then it may not move a great deal with the market’s ups and downs. There is very little embedded beta in its construction, and the risk really lies in whether the long and short positions themselves are correct.

  • Illiquidity: It’s important to remember that liquidity varies in the hedge fund space. Some are extremely liquid. Others are not. The key consideration is a proper match in the liquidity profiles of the underlying strategy and the investable vehicle itself. For instance, macro funds invest in Treasuries, equities, commodities, futures and currencies—the most liquid markets in the world. Alternatively, some credit-oriented funds take distressed positions in companies with a view to the long term, and will therefore have different constraints on redemptions.

  • Concentration: Hedge funds rarely invest in a whole index or market. They select only a few positions, albeit with a high degree of conviction, in order to optimize returns and minimize overlap with other, more conventional strategies. That said, concentration risks can be mitigated at the portfolio level by allocating to multiple hedge funds doing different things with low correlation to one another.

  • Complexity: Lastly, it’s crucial to work with a team that really understands the underlying strategies and does the necessary due diligence. With a vast number of available options, the ability to track and accurately compare a firm’s intangibles in a matter of experience.

Despite its reputation, the hedge fund industry has evolved through the years to have among the most sophisticated risk management teams, resources and technology in the investment universe. This is especially true when looking at a portfolio of hedge funds, where the composition of styles allows for a more diverse return package.

Myth #3: Hedge funds have lock-ups and high fees.

Reality: There is no archetypical hedge fund anymore—it’s more of a broad spectrum, from those that offer the flexibility to fully redeem every month to others where it takes two to three years. What we believe is non-negotiable, however, is the need to take an unconstrained approach when investing in hedge funds. If you apply too many restrictions, say, by only choosing highly liquid or low fee hedge funds, you are in effect narrowing the investment universe based on a factor other than quality. Our suggestion is always to look for the highest quality managers and then adjust for fees and liquidity, bearing in mind that market dynamics will always be at play. While some funds do charge high fees and have less liquid terms, if they are delivering exceptional levels of skill-based returns, the performance experience for clients can still be highly compelling.

Like most industries, there are market forces at play in the hedge fund space, meaning the space has evolved since the early days of the original “two and 20” model being applied across managers and strategies. Fees and terms can vary significantly based on the quality of returns being delivered to clients. As with any industry, the best-in-class tends to command higher fees.

In the investing world, this sometimes means lengthier lock-up periods because managers have proven their skills and earn the trust to demand a longer commitment from investors. In some situations this can ultimately benefit investors, as organizations with longer duration capital are able to reinvest in their business, build world-class infrastructure, invest in technology and data analytics, hire leading experts in their fields, optimize the talent within their firms, and so on. The very best firms are able to re-deploy higher revenues to ensure their competitive positions are sustainable.

An asset class unlike all others

Over the next decade, there is much debate about the outlook for equity returns and other traditional investments in a more normalized interest rate environment with inflationary pressures. In a historical context, some suggest this typically leads to lower returns for traditional assets than have been experienced over the last decade’s low-rate regime, with higher portfolio volatility.

In such an environment, hedge funds have the ability to provide an attractive diversifying source of return. But this depends significantly on the ability to identify and access the higher quality managers in the universe, as it is one of the most competitive parts of the asset management industry.

Philosophically, we often compare hedge fund investing to standing on a downward escalator: if you are static and do the same thing as you did in the past, you risk falling behind because the competition is always getting better. There’s unceasing pressure on hedge funds to innovate, to evolve, and to continuously improve in order to maintain the advantage over their peers. You have to keep walking up the escalator, constantly moving, in order to stay at the top. This requires an active and dynamic approach designed to reap the benefits the asset class offers over time.

For more information, contact your Regional BMO Global Asset Management Representative or the BMO GAM Alternatives Team at bmogamalts@bmo.com.

Note: The above article is not necessarily representative of the risks and characteristics associated with hedge fund products that may be sponsored or manufactured by BMO GAM. Before investing in such a product, investors are strongly advised to consult the product's offering documents to understand the applicable risks and features, and to contact their financial advisor to determine whether such a product is suitable for them. A hedge fund product is not without risk.

Definitions:

Quantitative easing (QE): A program where central banks seek to stimulate the economy by increasing the supply of money and purchasing financial assets.

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