Hedge funds have faced a difficult stretch, underperforming less-expensive alternatives for years. However, as lightly regulated managers with few investment constraints, hedge funds have a distinct advantage over traditional investments such as mutual funds.
For this quarter’s Fiduciary Perspectives essay, “Alternative Facts and the Evolving Role of Hedge Funds,” I reflect on the current market environment affecting hedge funds and their opportunity set. With increasing clarity about what is being delivered by hedge funds, discerning investors willing to stay the course know they should pay less for beta, whether traditional or alternative, and more for alpha. Given this growing view among investors, hedge funds face a pressing need to evolve.
Hedge funds that employ strategies systematically available from less-expensive alternatives face being displaced by those cheaper options. What they need to do is rethink their product pricing and/or sharpen their focus on harder-to-detect idiosyncratic risks (i.e., security-specific risks). Alpha in today’s public markets remains less scalable and less liquid than it was in the past. Hedge funds that focus on producing alpha from idiosyncratic risks have the opportunity to avoid being squeezed by lower-fee alternatives. Investors must be prepared to pay a lot for that alpha and be willing to commit their capital for a longer-term investment horizon.
