Hedge funds: suitable for qualified investors?

Are you invested in hedge funds, or has someone already advised you to invest in hedge funds? Then you probably have financial assets of over five million francs.

In most countries around the world, access to hedge funds is restricted. They are usually only permitted by law for the wealthy. In Switzerland, the legislator and Swiss Financial Market Supervisory Authority (FINMA) protect small investors from hedge funds. Only qualified investors are allowed to invest in them.

Qualified as fair game

In Switzerland, you can call yourself a qualified investor under the Collective Investment Schemes Ordinance if you have more than five million francs in liquid assets outside your pension fund and real estate holdings. (At your own request, you are also considered qualified with fewer assets if you confirm in writing that you have the experience and knowledge to invest in complex investment products).

As a qualified investor, you are suddenly of particular interest as an investment client. Asset managers, banks, and other financial intermediaries may then sell you any number of complex investment products as a private individual — even if you have no knowledge or experience in investment matters. You are now fair game for the investment industry and will be heavily courted.

Returns independent of the market?

What is the appeal of hedge funds? Hedge funds aim for a positive return, regardless of what the market is doing. That sounds more than tempting: suddenly it is no longer a question of risking your own capital in order to participate in long-term economic growth. It's about finding other sources of return on the market.

For this to succeed, the portfolio manager of a hedge fund must constantly beat the market and minimize market risk through hedging strategies.

Some strategies are simple and have been in use for decades. For example, pair trades: the hedge fund buys a share that it considers to be undervalued. At the same time, it sells short a share from the same sector that it considers to be overvalued compared to the first. If his bet works out, he will make a profit — regardless of what the market does.

Other strategies are newer and more complex. On behalf of hedge funds, many brilliant and well-trained minds are constantly working on finding new arbitrage opportunities to generate returns on the market with as little risk as possible.

Some of these strategies work very well in the short term.

Success often only in the short term

If you are a qualified investor, salespeople will regularly present you with hedge funds with an excellent track record. So they do exist, hedge funds with phenomenal track records. The only problem is that hedge funds lack persistence. This has now been confirmed by scientific studies.

Of 100 hedge funds that have been active over the last five years, around half will have delivered on their promise (before costs). (Statistically, this is to be expected.) However, the winners of the last five years are too rarely the winners of the next five years. Past performance is no indicator for future performance — this is always stated in the disclaimer. And rightly so.

Of course, salespeople only ever present you with the successful hedge funds. Don't fall prey to selection bias, and don't let this selection distort your view. If you were to invest in the 50 hedge funds that have been most successful in the past, then around 25 of them will again generate an excess return. The other 25, however, will underperform. This is a zero-sum game in the long term — before costs.

High fees as a problem

After costs, the picture looks even worse. Developing strategies and actively trading: This is time-consuming and requires the best minds. Hedge funds are handsomely remunerated for this. A management fee of 2 percent and a performance fee of 20 percent are typical.

However, even the management fee of 2 percent proves to be a yield killer in the long term. It drags down performance if it was positive before costs. And makes it even more negative if it was already below zero.

Performance fee is asymmetrical

The hedge fund only receives the performance fee if its strategy works and it actually makes a profit for its investors. That sounds fair at first glance.

But as an investor, you regularly pay a bonus to the winning hedge funds. However, you do not receive a penalty from the losing hedge funds. If you invest in several hedge funds, you typically always pay a bonus to some managers. You won't see a penny from the underperformers.

The structure of the performance fee is always asymmetrical. That makes it a call option. The hedge fund manager receives it free of charge from the investor. (Which, incidentally, encourages many hedge fund managers to take big risks. If their bets work out, they earn a lot. If their bets go wrong, only the investors lose).

High watermark offers only limited protection

Within one and the same hedge fund, the high watermark limits the performance fee. This rule means that after a bad phase, the fund must first make up the losses before it receives a performance fee again for new gains. This works as long as the funds are operated on a long-term basis.

In most cases, however, hedge funds that perform badly for several years in a row are simply closed. The new funds that come to replace them demand a new performance fee from day one — and new hedge funds are constantly coming onto the market.

More diversification?

When it comes to selling hedge funds, the main argument is usually the return. However, it is also often promised that you can diversify your portfolio with hedge funds: The source of returns is not the market as such. It is the price inefficiencies of securities.

However, this promise has hardly been kept since the last financial crisis. The capital markets have become increasingly efficient in recent decades. Price inefficiencies are becoming increasingly difficult to find — and they are disappearing faster.

Hedge funds are also contributing to this. Because when more and more brilliant and well-trained minds are looking for new strategies, they often only work for a short time — until other managers also apply the same strategy. Competition between hedge funds makes the market more efficient. This is good for the market as a whole. But bad for the individual hedge fund.

Lots of leverage, little liquidity

Because they are achieving less and less with their actual strategies, many hedge funds are making their bets with higher leverage. They speculate on credit. This regularly works well when market conditions are calm. In a crisis, it becomes dangerous, as the experiences of 2007 and 2008 show.

Back then, lenders recalled their capital. Stock exchange operators demanded additional collateral for derivatives and short sales. Anyone who does not have enough cash on hand in such a situation has to sell their investments. The search for liquidity leads to a downward spiral of distress sales and credit shortages.

Hedge funds are powerless against the demands of banks and brokers. They have to meet them. Hedge funds, on the other hand, arm themselves thoroughly against their own investors: capital withdrawals are contractually limited. Even in quiet times, they are frequently only possible with three months' notice. During the crisis, withdrawals were typically blocked for one or even two years via gating clauses.

Too good to be true

The promises made by hedge funds sound too good to be true: More returns. Independent of the market. And with more diversification. But what is too good to be true is often not true. Unfortunately, even as adults, we are not immune to believing in Santa Claus. Especially when he promises great presents.

In the case of hedge funds, it's usually not the investors who get the presents. Yes, hedge funds are very lucrative. But above all they are for their portfolio managers and distributors. The stars of the industry are among the richest people on Wall Street.

A return to prudence

Calpers, the largest pension fund in the US, decided in 2014 to liquidate its investments in hedge funds. Other large institutional investors have followed suit. More money is now invested in ETFs than in hedge funds. Today, professional investors in particular tend to choose this prudent path.