Hedge funds have grown substantially over the past decade as an alternative investment class for those who want returns not necessarily correlated with the overall market. These funds do not face the same restrictions as traditional funds such as mutual funds, and this freedom allows hedge fund managers to pursue a variety of unique investment strategies. Some of these investment strategies include long-short funds, relative value funds and commodity funds.
The Hedge Fund Difference
The freedom to short equities and trade in derivatives sets hedge funds apart from traditional mutual funds. Many investors believe that these exposures make hedge funds more risky, and in many cases, they are correct. However, the careful application of derivatives and short positions in a portfolio can yield solid returns that are not tied to any existing index, giving the investor instant diversification.
Similarities Remain – Risk is Risk
The hedge fund industry is intimately tied to the overall investment climate. In times of high economic risk like we are seeing today, investors tend to avoid riskier investments such as hedge funds and equities in favor of fixed income alternatives such as Treasury bonds. The redemptions caused by this shift in capital allocation impact not only the size of hedge funds, but also the fees that hedge fund managers collect. This then impacts the resources that hedge fund managers are able to bring to bear in the management of the portfolio.
Niche Markets Thrive
The New York Times captures this trend discussing the slowing in hedge fund inflows. While overall hedge fund asset growth has been on the decline since May of 2010, the article indicates that one of the bright spots in the industry has been fixed-income funds. Leon Mirochnik, an analyst at TrimTabs Investment Research, said “investors see these strategies as offering the best defense against unpredictable geopolitical issues.”
Other niche markets such as funds in Japan and macro based funds are also experiencing growth in light of the overall decline in the industry. This has been despite negative returns in the Japanese market in particular.
Opportunities in the hedge fund industry will be limited moving forward unless a reversal in the flow of funds occurs and assets under management begins to grow again. Quite simply, there isn’t enough money moving into the funds to justify the addition of resources. The exception to this trend is of course the niche market and the fixed income funds that are experiencing growth. Individuals with experience and knowledge of these niche markets may find some success in the hedge fund industry over the coming years.
With that considered, until a robust economic recovery gets underway, individuals will continue to avoid risky assets and hedge funds certainly fall into that class from the perspective of most investors. This will continue to be a drain on hedge fund assets under management for some time to come.