Why Do People Invest in Hedge Funds?

The reasons for investing in hedge funds vary. For some investors, hedge funds represent an opportunity to trounce the market. For others, hedge funds are a way to add an additional element of diversification beyond stocks and bonds. They do this by employing “alternative” strategies that can include everything from short-selling stocks to taking large positions in companies and actively influencing change.

But hedge funds aren't for everyone—and some people think they're a terrible deal.

For starters, hedge funds come with high minimum investments ($1 million is standard) and typically have lock-in periods during which investors cannot withdraw funds. Relative to mutual funds the fees are exorbitant: 2% plus 20% of profits is typical. Because these funds aren’t subject to the same regulations as mutual funds, it’s a lot harder to get a handle on what your hedge fund owns or even how it’s doing.

Speaking of performance, hedge funds are questionable. Over the five years through November 30, 2015, the Hedge Fund Research Fund Weighted Composite index is up an average of 3.2% a year, versus about 13% for the Standard & Poor’s 500 over the same period.

And yet, new hedge funds continue to open, and investors are still eager to invest.

“Hedge funds were started decades ago by a man who was such a good manager he told people he would manage for a percentage of the gain. For decades hedge funds were a very exclusive club,” says Ron Wiener, president of RDM Financial Group in Westport, Conn.

Today there are thousands of hedge funds in a wide range of categories, including absolute return, long/short, market-neutral and global macro, among others. “The industry started to diversify much like the mutual fund industry, and funds have started to get more esoteric,” says Wiener.

Meanwhile, over the last several years firms have rolled out hedge-fund-like mutual funds that are available to anyone. These “liquid alternatives” charge lower fees than hedge funds, are more transparent, and have daily liquidity, which is to say that you can redeem your shares at any point.

Nearly every major mutual fund company has entered the space either via alternative funds or non-traditional bond funds. At last count, there were more than 625 alternative and non-traditional funds tracked by Morningstar.

Despite questionable track records and high fees, hedge funds—or rather hedge-fund-like mutual funds—are gaining wider acceptance among mainstream investors who are looking for ways to insulate themselves from a repeat of the 2008 financial crisis. Still others worry that after decades of appreciation in the bond market they need to rethink the definition of a diversified portfolio.

“There is now a lot of discussion in investment circles that portfolios include some exposure to alternatives,” says Wiener. Instead of the 60/40 split of 60% stocks and 40% bonds it might be 60% stocks, 30% bonds and 10% alternatives, whether it’s in a traditional hedge fund or the new crop of mutual funds.