Hedge Funds After The Fall

bungee jumpingInterest in hedge funds is increasing in today’s investment landscape. These strategies can help investors meet many different goals, from risk management and diversification to capital preservation and asymmetric returns. The hedge fund industry has grown in size and breadth over the past two decades, and the diverse benefits such investments can bring to investors have proven themselves over time.

Indeed, the number of global assets managed by hedge funds overall has grown exponentially in the past 20 years, now amounting to over $2 trillion. While the industry benefited from a period of substantial expansion between 2003 and 2007, it experienced a pullback during the economic crisis. However, since 2008 hedge funds have come back—not only has the asset pool of hedge funds grown, so too has the number of strategies available. There are now roughly 10,000 hedge funds worldwide, just slightly below the pre-crisis peak (Source: HFR Industry Reports, January 17, 2013).

The reasons investors would seek to increase their hedge fund exposure vary. According to empirical data, most investors are interested in using hedge funds to increase portfolio diversification and to manage volatility by investing in strategies with low correlations to traditional equity and fixed income assets. Other reasons for investors to use hedge funds might include alpha generation, long-term growth potential, or protection from inflation (Source: Russell Investments 2012 Global Survey on Alternative Investing).

Downside protection

Historical data suggest the perceived benefits of hedge funds are borne out in practice. Hedge fund returns generally have low correlations to stocks and bonds and, when added as a complement to an existing portfolio of equity and fixed income investments, hedge funds can enhance risk–return profiles. In terms of downside protection, hedge funds historically have exhibited better capital preservation versus global equities during notable bear markets over the past two decades. Hedge funds overall have also outperformed corresponding global fixed income and equity indices over the same period.

The evolution of hedge funds points to possible future trends for the industry as a whole. As investors become more comfortable with these investments, they may look increasingly at customized solutions. Furthermore, we may see investors expand their use of hedge funds beyond simple portfolio diversification, taking increased advantage of the full range of benefits these strategies can provide.

Dan Elsberry, senior managing director, K2 advisors, Franklin Templeton Institutional