Why People Invest in Hedge Funds

Last week I shared some of my thoughts on hedge funds. In a follow-up to that piece I want to discuss some of the reasons that institutions and wealthy individuals allocate money to hedge funds. I’m not so much concerned with Sharpe Ratios and non-correlated returns. What fascinates me most about the investment business is how incentives and human nature drive people’s decisions.

(Full disclosure: My views here are colored by my experiences in the institutional investment industry and are probably biased in many ways. Not everyone feels the same way as I do on this topic, but that’s what makes market interesting.)

Some industry observers seem to assume that because CalPERS announced an exit from hedge funds earlier this year that there will be a mass exodus as others in the institutional investing world follow their lead. I don’t think this will be the case at all as I expect the industry to continue its massive growth over the coming years. Here are some of the reasons why:

Most hedge fund managers are brilliant. These people don’t raise millions or even billions of dollars without having a high level intelligence. When you meet face-to-face with the best hedge fund managers it’s almost impossible to walk away unimpressed. Most of the best funds have made it so you almost feel entitled and lucky to be handing over your money to them. That’s how good some of these managers are at persuading people of their brilliance. Some people will never be able to resist the charm of intelligence.

It’s interesting and it looks like a smart move to a board of directors. It’s much easier to blame others or come up with excuses when implementing a complex approach to portfolio management. Keep things too simple and you’re the only one to blame when things go wrong. I’m always amazed at how much people underestimate the role of career risk in the investment industry. It could be one of the biggest behavioral sources of market inefficiency out there when you consider how much money professional investors collectively manage.

Non-correlated returns, stock-like returns with bond-like volatility, upside participation with limited downside risk and alpha generation all sound very impressive when you have to answer to the board that oversees your institutional fund. If nothing else, hedge funds are interesting. The message is very appealing to certain groups of investors.

They have by far the best sales and marketing teams in the fund industry. With high fees come plenty of resources to hire the best and brightest to build your support staff. Not only are the portfolio managers interesting to talk to, but the people who manage the relationships for these funds are the best in the business. They have the the sales process perfected better than anyone.

There’s always a good time to invest in a hedge fund…just ask them. This is true with any money manager, but hedge funds have truly turned this into an art form. In the aftermath of the crash we were told we had to invest with them because, “Look what just happened,” playing up to people’s recency bias. And following the bull market we were told we had to invest with them because, “Another crash is on the way…” In general, hedge fund managers are the most paranoid, anti-Fed, anti-establishment investors out there. They’re very good at playing on investor fears to raise capital and fear sells.

For some, it’s a status symbol. I was sitting in on a panel a few years ago with a handful of mid-sized endowments and foundations. These funds had a few hundred million dollars compared the the billions managed by everyone else in the room. One CIO told the crowd that his fund “only” had 20% of their fund allocated to alternatives like hedge funds.  But he was quick to point out that the allocation would certainly grow in the coming years. It was like he was ashamed that his organization’s portfolio didn’t have 50-70% in alts like everyone else (pretty standard these days for larger funds). Peer pressure and the status symbol of creating a “sophisticated” portfolio is a real issue for many of these organizations, whether they’re willing to admit it or not.

There’s an assumption that you get what you pay for. Higher fees lead to better performance, right?

And that a complex approach must be better. The more clever the pitch the better the performance, right?  

Follow the leader. Consultants, advisors, family offices and institutional investors are constantly looking at best practices to keep up with the rest of the industry. On the institutional side of the business there is plenty of peer-to-peer sharing of manager recommendations and due diligence that goes on because no one wants to be surprised by a lack of information. Everyone likes to think they’re a contrarian in this business, but it always feels much safer to go with the herd and do what everyone else is doing. Hedge funds are a perfect example of this as the large allocators of capital typically all invest in the same funds.

Emerging managers. Every year there are a few emerging hedge fund managers that come out of nowhere and shoot the lights out with their performance. If you can find these emerging funds before everyone else does the returns can be spectacular. As with most things, this is easier said than done. I’ve seen many emerging manager fund-of-funds crash and burn, even though that’s their entire line of business.

The Holy Grail in this space is the fund manager who doesn’t want to become institutionalized and is content managing money for a small number of investors and never wants to get too big. It’s very rare, but I’ve seen a handful of these types of funds.

There are funds out there with amazing track records. It’s not like it’s all smoke and mirrors. Some people out there seem to assume that rich people and institutional investors really just like shoveling money into the furnace by paying 2&20 to underperforming hedge funds. As I said in my last hedge fund piece, there are great funds out there. But the chances that you are going to have access to them is slim to none. Yet hope springs eternal.

Ego. Most big investors are unwilling to admit that they’ll never be able to invest in this small group of outperforming funds or pick the best emerging managers, but that doesn’t stop them from trying.

Sure it’s a tough business for everyone else, but we have the best due diligence process in the industry. We have all the right connections. Our access is unprecedented.  We only invest in top quartile managers. It’s everyone else that pick the bottom of the barrel funds.

It’s amazing how many people assume they only invest in the top echelon of funds. It makes you wonder who all these people are investing in the rest of funds out there. It has to be someone. The fact remains that the majority of investors in hedge funds are ill-equipped to invest in this space. Most people have been or will be disappointed by their hedge fund investments.

One of the biggest reasons for this is that they don’t know why they’re invested in them in the first place.

Further Reading:
My Thoughts on Hedge Funds
Does CalPERS Need a Simpler Approach?