Are Hedge Funds Worth the Risk Today?

Michael Sonnenfeldt, the chairman of “ultra-high-net-worth” network Tiger 21, has declared that hedge funds are "dead as a doornail," as his members’ allocation dropped to just 2% — down 10 percentage points from 2008.

But for a wide range of return-oriented investors, hedge funds are still very much alive and well and a key part of a successful portfolio in this era of runaway stock valuations.

It’s not a surprise that Sonnenfeldt and other market observers are looking at trends around hedge funds and saying their final rites. Index funds have been on a tear since the Great Recession, and asset classes of all types have struggled to measure up. Strong performance in the broader stock market is always going to lessen the appeal of hedge funds, which are both more expensive to access and offer less liquidity than index funds.

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But the performance of hedge funds and the retreat by a group of savvy centimillionaires from them cannot be evaluated in a vacuum. When the Tiger 21 members had their maximum allocation in hedge funds, the global economy was in a free fall. Banks were failing, companies were teetering, and the S&P was tanking.

The 8% loss that hedge funds incurred was far less than the 39% loss suffered by the S&P. Hedge funds were one of the smartest places to put money in 2008.

A different story today

Today, however, we’re looking at almost the inverse scenario: The stock market has been performing remarkably well since the Great Recession, and index funds have benefited from what’s essentially been a secular bull market — strong, save for a few pandemic-related blips.

But the strength of the market today should never be taken as a promise for tomorrow. Playing the puck where it is rarely makes for good investment strategy, and to keep the metaphor, there are plenty of worrying cracks in our current economic ice surface. Against that backdrop, holding hedge fund assets as part of a healthy portfolio just feels smart.

What we’re seeing right now is an onion economy: Looking at the surface of the index, it seems to be performing well. But as we peel back the layers, it’s clear that it’s really just a small subcategory of that index that's generating the majority of that return.

It’s well known at this point that the S&P 500’s remarkable growth last year hinged almost entirely on the backs of the Magnificent 7 tech companies. It’s a trend we’re more than likely to see repeat this year, as Nvidia (NVDA) continues to blister its way through the market, reaching new highs and setting records.

All of this is good news for index funds and those invested in them — and point to clear trends about where the market is headed. AI and computer chips are going to continue to set the world on fire and seemingly usher in new waves of investor dollars chasing tech-driven returns.

Looking beyond the Magnificent 7

But the rest of the market isn’t resting on such sure footing. Without the Magnificent 7, the equal-weight index of the S&P is just 4.72%, a significantly less impressive growth metric. Meanwhile, the small cap index is up just 0.5% year to date. Without the glimmer of AI to urge it along, the performance of the index is merely average.

None of this means that these are necessarily bad companies, but collectively signs point to a possible market retrenchment. When that happens, the index funds will suffer; investing in the S&P only works until it doesn’t work.

When it doesn’t, investors are going to need and want diversification in their portfolios — diversification that hedge funds are well-positioned to provide right now. In general, hedge funds typically benefit from having a lower correlation to the stock market and a lower beta. They allow for more selective strategies than blanket index funds, giving investors more selection over whether they pursue an event-driven strategy or one that’s more market neutral. At the right fund, investors can actually find better performance with lower risk.

I know of funds that regularly outperform the S&P 500 by over 3% per year when evaluated over the long term. Other hedge funds were up by more than 10% in 2022, when the S&P as a whole was down 19%.

Hedge funds are not without drawbacks

While access to many of the top-performing hedge funds require being a qualified purchaser investor, for the individuals who can invest, it’s often worth it. These funds have much better long-term track records than what’s generally available on the mass market.

But obviously, the active management, research and technology platforms these funds require come with high fees and a minimum one-year lockup period. And even then, the best-researched and managed funds can still have periods of fluctuation compared to broader market indexes.

But as the less-than-Magnificent 7 stocks on the S&P continue to struggle, investors are going to want the more nuanced approach to stock selection than is available from index and mutual funds. Hedge funds are going to be a key part of that more selective mindset, one that allows for risk management as the economy is thrown for a loop in the era of AI.

Hedge funds aren’t dead, and events in the not-so-distant future just might find investing tigers roaring for them again.

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