In a modern world characterized by uncertainty and risk, a growing number of investors are looking to hedge funds as a means to shield their assets against volatility, produce more predictable returns, and secure their financial future. But as with any other investment vehicle, knowing whether hedge funds have historically mitigated downside risk and acted as the shield they’re reported to be is crucial to investing with confidence. Let’s take a closer look at whether hedge funds successfully mitigated downside risk over the past 20 years and what it means for the clients you manage.
Hedge Funds Are Subject to Criticism, But Is It Accurate?
Hedge funds, like a wide range of investments, have their fair share of myths and misconceptions that can prevent investors from making a commitment to these investment vehicles.
The first and most obvious that should be addressed is the volatility and failure rate surrounding hedge funds. Some investors may be deterred from putting their money into hedge funds because they’ve heard that hedge funds are far more volatile than other investment opportunities like traditional equities. But is this true?
Available data actually seems to support the opposite. Take, for example, the dot com bubble. During this time, one source found that the S&P 500 drew-down 45% while hedge funds only dropped around 5%, a staggering difference that can have a massive impact on your wealth in a matter of moments. But even during times of relative stability throughout the past 20 years, hedge funds experienced less volatility than the S&P 500.
Of course, this is just one source identifying trends between hedge funds and U.S. equities. Is there more data to prove that hedge funds have been able to mitigate downside risk effectively?
There is.
While the previous source looked at the relationship between the S&P 500 and hedge funds over the past 20 years, another evaluates this relationship for the past 30. What they found is that, over the past three decades, hedge funds experienced less volatility while producing comparable returns, with the S&P 500 experiencing 14.3% annualized volatility and offering 9.9% annualized returns and hedge funds experiencing 6.5% annualized volatility and producing 9.3% annualized returns.
Continuing with this study, they also took a closer look at volatility during more difficult economic periods, which can test and determine risk far more effectively than during times when the market is performing well. The first period they looked at was from 2000 to 2002, which revealed that the S&P 500 experienced a 24% drop in returns with an 18% spike in volatility. Meanwhile, hedge funds only experienced a 0.1% decline in returns with a 6.8% rise in volatility.
The second period they assessed was between 2007 to 2009, when the S&P 500 experienced an even greater decline in returns with a drop of 38.9% and increased volatility spiking up to 19%. During this same period, hedge funds experienced a 12.4% drop in returns and a 9.1% increase in volatility.
Regardless of who you turn to in order to assess whether or not hedge funds truly mitigate downside risk, data always supports the fact that hedge funds are a much safer investment vehicle to put money in order to experience healthy returns but avoid extensive market volatility over time.
Why Have Hedge Funds Proven to Be Such a Valuable Asset for Investors?
There’s a reason why hedge funds mitigate downside risk and experience less volatility than equities, and it’s due to the way that the funds are managed. Whereas equities only shine and support investors during times of positive market performance, hedge funds bolster investor funds over time due to strategic diversification.
While the method of management and strategies used will naturally vary, many hedge funds use strategies like the long/short strategy to mitigate downside risk and support investor goals. The long/short strategy focuses on taking the long position for stocks that managers anticipate will rise in value over time while shorting stocks that are believed to decline in value.
Some of the other strategies include merger arbitrage, by which managers will bet on a merger or acquisition happening as anticipated, and market neutral funds.
Another benefit of note that investors should keep in mind as they search for the right hedge fund is the reduction in fees over the years. Hedge funds have commonly been associated with high fees, with many demanding a 2% management fee as well as a 20% performance fee. Continuing with the source provided above, hedge fund fees appear to have fallen in recent years, with the average hedge fund only requesting a 1.26% management fee and a 14.81% performance fee.
Overall, hedge funds have mitigated downside risk successfully due to their diversification and structure, and these investment vehicles only seem to continue to offer more to investors looking to shield their wealth against market volatility while also receiving desirable returns over time. With the advent of new technologies like AI and Blockchain, it’s exciting to see how hedge funds will evolve to better support investor needs now and in the future.
But with the above in mind, hedge funds are only as effective as the management behind them. What do you need in order to better support investors who come to you with their wealth so that you can guarantee mitigated risk and reliable returns?
Manage Your Hedge Funds More Effectively With FundStudio
FundStudio is a financial solution that supports hedge funds, asset managers, CTAs, and beyond with a multi-asset-class risk and portfolio management system, reporting and operations platform, and outsourced managed services (also a choice between a cloud-based platform or a hybrid) that companies can use to streamline their operations, reduce potential risks and mistakes, and maintain greater confidence with how they’re handling client funds. If you want to support investors as they look to hedge funds to mitigate downside risk and grow their wealth, FundStudio is an excellent, multi-faceted solution to put your trust in. Request a demo of our platform or a meeting today.