Hedge funds have exploded in numbers since the 2000s. However, their growth has slowed down significantly in recent years due to shifting market conditions in an unstable global economy and stiff competition from private banks, investment firms, and private portfolio managers in the high-net-worth sector. However, despite this slowdown in growth, the more than 30000 strong hedge funds industry continues to hold a significant share of global assets under their management. This article provides insight into what hedge funds are, how they invest in, and how they fit into the portfolios of family offices and other wealth management institutions across the globe.
What are Hedge Funds?
A hedge fund is an offshore fund that is designed as a “pooled” investment vehicle and structured as a limited partnership of a fund manager and the investors who contribute to its operations and management. Hedge funds typically trade in public markets like securities and employ aggressive strategies like the long/short equities model where stocks are not only held for long-term value appreciation but also shorted during periods of market instability to benefit from momentary changes in their value.
Thanks to their unique characteristics, hedge funds are an attractive investment option for high-net-worth individuals and family offices. Firstly, they are only accessible to accredited investors with a minimum net worth of $1 million. This sets them apart from other pooled investment funds like mutual funds which are typically open to all individual investors who are willing to pay the service fees. Secondly, hedge funds have more aggressive investment strategies. They generally make use of leverage and invest in diverse asset classes like securities, real estate, alternatives, and derivatives in order to maximise their return potential at the cost of increased risk exposure. They also employ aggressive strategies like long/short equity, arbitraging, etc. Last but not least, hedge funds are open-ended and actively managed funds. This allows investors to add to the funds at any point in time. Closed-end funds do not allow investors to contribute to them during the lock-in period.
This makes hedge funds a popular option for investors seeking higher returns through higher risk exposure, and the ability to invest in strategies not typically available in traditional investment vehicles. However, it’s important to note that these investment strategies also come with increased risk, and hedge funds are not suitable for all investors.
Family office vs Hedge fund: What is the difference?
While both hedge funds and family offices are wealth management solutions for high and ultra-high-net-worth families respectively, their similarities end there.
Perhaps the most distinguishing factor between the two is the scope of services that each provides. Hedge funds can only be categorised as alternative investments that can generate outsized returns using aggressive, risky, and complex investing strategies. Family offices, on the other hand, offer personalised and comprehensive wealth management solutions for their clients which includes, but are not limited to, asset management, legacy planning and generational wealth management, concierge services, taxation services, and family financial education. For UHNW families, the services of a family office can go a long way towards the growth and preservation of their generational wealth.
However, one of the key downsides to a family office is the running costs associated with it which can often go as high as 2% of the family’s total active assets. Hedge funds, on the other hand, set minimum investment criteria which can range from $100,000 to $2 million per investor, and operate on a two-twenty fees structure, as mentioned above.
Despite their inherent differences, family offices and foundations are important sources of investments for hedge funds.
From a hedge fund to a family office
In 2020, hedge fund celebrity John Paulson shut down his firm to convert it into a family office structure. A year earlier, David Tepper also made the same move with his firm, Appaloosa Management, which was largely considered an outperformer in the market.
This trend is hardly a new development in the industry. Hedge funds have increasingly been adopting the family office route due to various reasons like high operational costs, increased investor pressures and market volatility, and most importantly, increased regulatory scrutiny. When these hedge funds “convert” to a family office, they exist as hybrid entities to evade Securities and Exchange Commission norms that they’d have had to face according to the 2008 Dodd-Frank legislation.
It is very clear that full-fledged family offices are still the way to go for UHNW families looking to grow and preserve their wealth. Hedge funds will continue to exist as potent alternative assets for these family offices as part of their portfolio diversification strategies.