Hedge funds have long been shrouded in mystery for most everyday investors. Traditionally the domain of institutional investors like sovereign wealth funds, university endowments, and pension funds, these sophisticated investment vehicles have remained largely inaccessible to Main Street. But what exactly are hedge funds, and why do large institutional investors continue to allocate billions to them despite reports of underperformance compared to simple index funds?
To understand hedge funds, we first need to grasp what differentiates them from traditional investment vehicles. Unlike mutual funds or ETFs that typically only go “long” on investments (betting that assets will increase in value), hedge funds have the flexibility to go both long and short, allowing them to potentially profit in both rising and falling markets. This flexibility extends to the types of assets they can trade—from stocks and bonds to currencies, commodities, and derivatives—giving them a vastly larger opportunity set than most traditional investment vehicles.
One of the most common misconceptions about hedge funds is that they’re designed to maximize returns at all costs. In reality, most institutional investors turn to hedge funds for consistency and diversification rather than outright performance. Consider a university endowment that withdraws about 5-6% annually to fund operations. What they’re seeking isn’t necessarily the highest possible return, but rather a reliable 6-8% annual return with minimal drawdowns. Hedge funds, with their focus on risk management and their ability to perform in various market environments, can help provide this consistency.
This focus on risk management is perhaps the most underappreciated aspect of hedge fund investing. As Bob Elliott, formerly of Bridgewater Associates (once the world’s largest hedge fund), explains, “Risk management is, in some cases, almost more important than even the edge that is being constructed.” Successful hedge fund managers understand they’ll be wrong nearly half the time—similar to how even the greatest tennis player in history, Roger Federer, only won 52% of his points. Their skill lies not in avoiding losses altogether, but in cutting losses quickly while letting winning trades run, creating an asymmetric return profile that can deliver consistency over time.
The infamous “2 and 20” fee structure (2% management fee plus 20% of profits) has been the standard in the hedge fund industry for decades. However, this structure, combined with the tax inefficiency of typical hedge fund structures, can dramatically erode returns. A hedge fund generating a 10% gross return might deliver only 6% after fees. After taxes (hedge funds are typically structured as partnerships with pass-through taxation), that might drop to 3%. Add in additional access fees, and the investor might only see a 2% return—hardly worth the complexity and illiquidity.
This recognition has sparked innovation in making hedge fund strategies more accessible to everyday investors. ETFs that replicate hedge fund strategies or provide exposure to alternative asset classes are becoming increasingly popular. These products offer the potential benefits of hedge fund strategies—diversification, non-correlation with traditional assets, and more consistent return profiles—without the high fees, tax inefficiency, and liquidity constraints of traditional hedge funds.
For Main Street investors considering their options, the key takeaway is to focus on what matters most: the net-of-fees, net-of-taxes outcome. Whether investing in traditional or alternative strategies, understanding the true cost of an investment strategy and its expected after-tax return is crucial. Additionally, considering how a strategy might perform in different market environments—particularly challenging ones—can help build a more resilient portfolio that doesn’t rely solely on making a directional bet on continued economic growth.