Who Invests in Hedge Funds—and Why?

The primary investors in hedge funds are institutional investors. These are professional investors who manage large amounts of money. They work for pension funds for corporations, government workers, and labor unions. They also manage sovereign wealth funds for entire countries. They handle the cash assets of insurance companies, other corporations, and trusts. Institutional investors provide 65% of the capital invested in hedge funds.

Qualifications

Hedge fund investors are required to have at least $1 million in net worth or must have earned income above $200,000 in each of the two preceding years. They also must reasonably expect to earn that amount for the current year. They need this cushion to weather significant downturns in their portfolio in their quest for higher returns. They also must be able to keep their money tied up for the three or more months, as may be required by hedge funds. Three years is a typical time frame to evaluate the success of a hedge fund’s performance.

Investors often must be willing to pay 2% of the assets they invest and 20% of any profits. This high fee is worth it to them to outperform the market. Some are still trying to recover losses incurred during the crash of 2008.

These are sophisticated investors. They understand how leveraging works through options, futures contracts, and the other derivatives that hedge funds use to boost returns. They are willing to endure the risk of the investment going south.

They also need to be good judges of character. Most hedge funds don't reveal what they do to get their returns. That lack of transparency means that they can actually be Ponzi schemes, such as the one run by Bernie Madoff.

Why They Invest in Hedge Funds

Those big investors put less than 20% of their assets into hedge funds. More conservative investors—like insurance companies, pension funds, and sovereign wealth funds—allocate less than 10% of their total investments.

Hedge fund investors are looking for an investment that is uncorrelated with the rest of their investments. If the stock market loses value, the hedge fund investment might rise. In other words, investors use hedge funds to increase their diversification. They know that a diversified portfolio will increase total returns over time by reducing overall volatility. 

Surprisingly, most hedge fund investors aren't looking for higher-than-average returns. Only 6% think they could achieve 10% or more annual returns. They just aren't willing to endure the risk that higher returns entail. Instead, 67% are looking for annual returns of between 4% and 6%. That's probably because they have to report to boards that might fire them if they sustain losses.

Family trusts use hedge funds to gain access to the best minds in the investment world. Why do hedge funds attract the smartest investors? Because they pay the most. But many investors may limit or even avoid hedge funds due to the high fees.

Investor Trends

Pension funds recently started investing in hedge funds to boost returns. They realized that they might not have the capital needed to cover the mass of retiring seniors and are trying to outperform the market to cover those obligations. Unfortunately, the risky nature of hedge funds and their lack of regulation means that these pension funds are less likely to cover their commitments.

There is some indication that hedge funds are becoming less popular. In 2014, they returned only 3.3% on average, much lower than the S&P 500. Almost as many hedge funds are liquidated each year as are created. Many savvy investors realize that they are taking all the risk, while the hedge funds aren't producing rewards to offset or justify that risk. 

The California Public Employees' Retirement System announced that it would withdraw all of its $4 billion in hedge funds in 2014. It had only received a 7.1% return in the past year. That sounded good until it was compared to the 12.5% return of a comparable investment, the Vanguard Balanced Index Fund, with an asset allocation of 60% stocks and 40% bonds.

It appears that institutional investors are continuing to view hedge funds as a source of alpha and diversification.