Hedge Fund Investing Chapter 2 Part 1: Who Invests in Hedge Funds?

Hedge funds started back in the 1960s when Alfred Winslow Jones launched the first one. It was weird at the time because he used leverage and short selling. Nobody else was doing that. But the industry stayed small until the late 1980s.

What changed? Media coverage. Paul Tudor Jones made a killing during the 1987 stock market crash. Then George Soros became famous for betting against the British pound. Regular rich people saw these headlines and thought, “I want in.”

This chapter is about who actually puts money into hedge funds and why they do it.

What Does the Research Say?

Before institutions started throwing billions at hedge funds, there was a bunch of academic research that basically said: yes, this is a good idea.

The early studies found that adding hedge funds to a traditional stock-and-bond portfolio reduced volatility and improved returns. Researchers like Fung and Hsieh (1997) used multi-factor models and found that hedge funds had low correlation to traditional markets. Lo (2005) confirmed the same thing. Low correlation to stocks. Low correlation to bonds.

That is the magic word in portfolio theory. Low correlation. When your hedge fund zigs while your stocks zag, the overall portfolio becomes smoother.

Here is what the research found in favor of hedge funds:

• Adding them to a traditional portfolio reduces volatility
• They protect capital when stocks and bonds go down
• They give access to markets and products regular investors can’t touch
• Different hedge fund strategies have low correlation to each other
• The best managers have low exposure to traditional market drivers

But it was not all sunshine. Researchers also warned about real risks:

• Many strategies have weird return distributions, so standard measures like the Sharpe ratio don’t work well
• Some strategies expose you to fat tail risks (the “everything looks fine until it really isn’t” problem)
• Hedge funds are illiquid, and leverage can create mismatches between what the fund owns and what it owes
• Data quality issues like survivorship bias make results look better than they really are

The bottom line from all the academic work: hedge funds can expand the efficient frontier. Meaning you can get more return for less risk. In theory.

How Hedge Funds Fit Into Asset Allocation

The basic idea is simple. You have stocks, bonds, and cash. You mix them to get the best return for the least risk. Adding hedge funds gives you a fourth bucket that has low correlation to the other three.

Mirabile walks through a math example. Take a 50/50 stock-bond portfolio. Expected return: 8%. Standard deviation: 6.73%. Now split it three ways equally between stocks, bonds, and hedge funds. Expected return goes up to 8.68%. Standard deviation drops to 5.45%.

More return, less risk. That is the sales pitch.

An unconstrained optimizer (a model with no rules) might tell you to put more than 50% into hedge funds. In practice, nobody does that. Most allocations cap out at 50% or less because of liquidity concerns, transparency issues, and reputational risk.

There is also an interesting optimizer result: if you just want to minimize risk, the model says put 0% in stocks, 58% in bonds, and 42% in hedge funds. That gives you 6.51% return with only 3.65% standard deviation. The reward per unit of risk (1.78) is much higher than any other combination.

Individual vs Institutional Investors

Hedge funds started as a rich people club. Early investors found managers through family connections, friends, or financial advisors. The funds did not advertise. They operated in secret. People wanted those legendary 30%+ returns from managers who left Wall Street to manage their own money.

Over time, the mix shifted. Institutional investors (pensions, insurance companies, sovereign wealth funds) came in later because they approach everything more analytically. They need committees, boards, and academic justification before writing a check.

According to KPMG data, high-net-worth individuals now represent only about 24% of all hedge fund investments. The rest is institutional money. Big shift from the early days.

One thing both types of investors liked: hedge fund managers invest their own money in their funds. That is skin in the game. If the fund loses money, the manager loses too. This is different from mutual funds where the manager collects a fee regardless. The incentive fee structure also means the manager only gets their performance bonus if the fund makes money. And if the fund lost money before, the manager has to earn those losses back first (the high-water mark) before collecting any incentive fee.

High-Net-Worth Individuals

The industry defines high-net-worth individuals (HNWI) as people with liquid assets of $1 million or more and overall net worth above $5 million. These people invest through financial advisors or private banks.

Why do they invest in hedge funds? Absolute returns, low correlation, unique strategies, broad mandates, capital protection, and honestly, some star quality. Being invested with a famous hedge fund manager is a status thing.

A typical recommendation from a private bank might look like this: move from a simple 70/30 stock-bond split to something like 40% equity, 30% bonds, 30% alternatives. Studies showed that this kind of shift increased returns from about 2.41% to 4.52% over a 10-year period while also reducing risk from 12.93% to 10%. That is an 87% improvement in returns with a 22.67% reduction in risk.

Family Offices

Family offices are private investment firms that manage money for wealthy families. Think Rockefeller, Gates, Tisch. These families hire professional managers to invest across generations.

They are sophisticated and they are long-term. Both things make them natural hedge fund investors. They don’t need to report to a board. They don’t face political pressure. They can make quick decisions.

According to Barclays Capital research, endowments, foundations, and family offices allocated the highest percentage of their capital to hedge funds among all investor categories. Insurance companies allocated the least.

University Endowments

University endowments are dedicated pools of money donated to support universities. Harvard and Yale are the famous examples. They have allocated more than 40% to alternatives, sometimes over 50%. Hedge funds specifically can be anywhere from 5% to 35% of total assets.

Universities have a few advantages. They lean on alumni and faculty expertise. They can move fast. And they are truly long-term investors. A university endowment does not worry about quarterly earnings. It thinks in decades.

Over the past decade, the biggest shift in endowment allocation has been from bonds into alternatives. Traditional fixed income just was not cutting it for returns, so endowments moved that money into hedge funds and other alternative investments.

Previous: Chapter 1 Part 2: Strategies, Leverage, and Performance | Next: Chapter 2 Part 2: Pensions, Sovereign Wealth, and Funds of Funds

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.