The success of a few institutions in investing in hedge funds has many others considering the option, but given the problems with liquidity and fees, institutions are probably better served by mutual fund alternatives.

This probably wouldn’t be the case if hedge funds had stuck to their original knitting. Alfred Jones is often credited with creating the first hedge fund in 1949. His fund went long on some positions and short on others, in essence “hedging” equity risk. Today, however, hedge funds use a wide range of strategies, well beyond the long-short model of Jones’ fund. Some funds use specific events such as mergers and buyouts. Others look at macroeconomic factors in selecting securities. Still others simply engage in market timing with individual securities, sectors or entire markets.

As University of Chicago professor John Cochrane has stated, “Hedge funds are not a new asset class. They trade in exactly the same securities you already own.” Indeed, the term “hedged fund” originated from the way the fund invested, not the type of investment.

Nevertheless, we can look at how hedge funds have fared against more traditional asset classes. My BAM Advisor Services colleague and CBSNews.com blogger Larry Swedroe compared the HFRX Global Hedge Fund Index to the indexes representing common asset classes. Through October, the hedge fund index posted a 2.2% return, trailing each major domestic and international equity asset class and beating out only short- and intermediate-term government bonds. It lagged long-term government bonds by 1.4%.

Liquidity
The experiences of two endowments illustrate how the liquidity issues tied to hedge funds can cause investment plans to backfire. The Harvard and Yale university endowments have often been lauded for their returns, and a large chunk of those returns have been due to illiquidity premiums from investing in vehicles such as hedge funds.

However, that lack of liquidity bit hard during the recent financial crisis, when Harvard’s hedge fund holdings fell 18.6% during the university’s 2009 fiscal year, contributing to an overall loss of 27.3%. Likewise, Yale’s endowment suffered a 24.6% loss during its 2009 fiscal year. The endowment’s year-end report noted that its portfolio, with 95% of the assets invested in equity-like strategies, was strongly impacted when “diversification failed to protect asset values, and illiquidity further detracted from performance.”

It’s easy to get seduced by the potentially outstanding returns offered by portfolios with heavy amounts of alternatives, such as hedge funds. Harvard, for example, had an average annual return of 7% for the period 2001–2010, while the S&P 500 Index returned 1.7% per year. However, you also have to remember times like 2009 and the impact it can have on your clients’ mission.

“The main lesson is that liabilities matter, and they didn’t invest according to their liabilities,” Columbia University’s Andrew Ang told Financial Advisor magazine. “One-third of [Harvard University’s] operating expenses were paid by the endowment, but they managed it as though they had no explicit liabilities. Endowments achieved high returns with illiquid investments through 2008, and then that risk bit back.”

In early 2012, Financial Advisor magazine reported that Jane Mendillo, the Harvard Management Company CEO, was reallocating the endowment to improve liquidity. The key point here is that even if returns on hedge funds look good, you have to consider your clients’ potential needs for their capital. Do they have a need so great that it means taking the risk of having no access to capital when it may be needed most?

Discipline
Institutions must consider whether they have the discipline to remain invested in hedge funds during periods of bad performance. The Wall Street Journal cited a study by Emory University professor Ilia Dichev showing that hedge funds returned 12.6% annually for the period 1980–2006, but investors only earned 6% per year. The gap was mostly due to managers chasing the funds with the best performance. Mutual fund investors lost about 1.5% per year over the same period because of performance-chasing behavior.

Institutions considering hedge funds need to take a serious look at their investing patterns to ensure they’ll be able to stick with their choice when performance may not be there. Any institution that frequently switches its investments may not see enough benefit from investing in hedge funds.

Costs
Costs remain a significant issue when considering hedge fund investments. Typically, hedge funds will take not only a percentage of assets, but also a cut of any profits made by the fund. A common hedge fund structure may be 2% of assets and 20% of profits, though some may charge much more. These fees may be understandable if the performance is there, but more often than not, the performance is lacking.

David Swensen, chief investment officer of the Yale endowment, said, “In the hedge fund world, as in the whole of the money management industry, consistent, superior, active management constitutes a rare commodity. Assuming that active managers of hedge funds achieve success levels similar to active managers of traditional marketable securities, investors in hedge funds face dramatically higher levels of prospective failure, due to the materially higher levels of fees.”
In fact, when Yale invests in alternative assets, it has the advantage of negotiating fee structures. For most institutions and nonprofits, the standard 2/20 fund-of-funds fee structures are not favorable.

Summary
For most institutional investors, publicly traded assets should serve as their portfolios’ foundations. For those looking to diversify risk, primarily of equities and fixed income, some alternative investments may be attractive. Prudent alternative investments have the potential for increased exposure to compensated risk factors as well as reduced correlations among a portfolio’s holdings, which contribute to reduced portfolio-level volatility.

Examples include non-traditional equity classes, such as U.S. micro-cap, international value, international small/small value, emerging markets and real estate investment trusts. Exposure to a low-cost, broadly diversified portfolio of commodity futures through a mutual fund and exposure to Treasury inflation-protected securities (TIPS) or other inflation-indexed bonds can also be appropriate.

Non-traditional assets such as hedge funds can make sense if the fees are reasonable. Or, as an alternative, investors can consider the mutual fund counterparts that some hedge funds have launched in recent years. The expenses of these funds are lower and do not come with performance incentive fee structures that encourage fund managers to take excessive risk.

AQR Funds, for example, has launched a number of funds that provide hedge-like strategies at a lower cost. For example, Buckingham Asset Management in St. Louis has recommended the use of AQR’s momentum funds, with fees ranging from 0.49% to 0.65%, to some of its institutional clients. By including exposure to momentum in a low-cost, diversified manner, portfolios gain exposure to a strategy designed to complement, or hedge, the equity strategy we recommend to our clients.

Tiya Lim is the director of institutional advisory services for BAM Advisor Services, a sister firm of Buckingham Asset Management that provides back-office services to RIA firms across the country.