Are hedge funds suitable for retail investors?

¶ … Skill Hypothesis

The regulation and incentive hypothesis

The reasons as to why companies shun hedge mutual funds

In this paper we evaluate the question "Are hedge funds suitable for retail investors?." We use the relevant theory in showing the reasons as to why retail investors too can benefit from hedge funds. A conclusion is also provided

Hedge funds which is defined by Connor and Woo (2003,p.28) as an investment vehicle which is actively managed and pooled and is open to just a limited number of investors. The performance of hedge funds is measured using absolute term units. Agarwal, Boyson and Naik (2007,p.2) noted that in the recent past, companies have began offering funds using hedge funds as an option.They employ them as trading strategies that are designed to effectively benefits the investors from any potential acts of mispricing on both the long and short-term. In this paper, we investigate if hedge funds are suitable for retail investors.The suitability of hedge funds for retail investors is a subject which has been debated by a number of scholars (Agarwal, Boyson and Naik, 2007). A review of literature seems to suggest that hedge funds are suitable for retail investors under special conditions. Hedge funds are defined as mutual funds that are made to intentionally emulate the various hedge fund strategies in order to enhance performance.

Who is a retail investor?

A retail investor refers to an individual who buys small amounts of public and private securities for himself. This is as opposed to an investor from an institution (institutional investor).

Hypothesis surrounding the suitability of hedge funds

The regulation and incentive hypothesis

The regulation and incentive hypothesis claims that hedge mutual funds will definitely underperform the hedge funds as an ac result of the significant differences that exists in the incentives as well a regulations between the two equally important industries. This hypothesis is indicated by Agarwal, Boyson and Naik (2007) to hold true since hedge mutual funds are generally indicated to underperform the hedge on the net-of-fee basis (by close to 4.1% per annum) as well as on the basis of gross-of -- fee.

The interpretation is that tightening of the regulatory environment in the mutual funds would serve to limit the borrowing of the funds to about a third of their assets. This also provides daily liquidity as well as the pricing for covering short positions. These restricts the ability of the hedge funds to effectively implement strategy with similar freedom that they possess in the hedge environment. The hedge mutual funds are also noted to provide a weaker level of incentives for the delivery of superior performance in the utter absence of compensation that is based on performance.

The Strategy hypothesis is the next theory that is used in the prediction of the fact that the hedge funds will outperform the mutual funds because the possess a greater level of investment flexibility .They also use strategies that can effectively take advantage of the favorable market conditions. The greater flexibility is associated with a potential rise in agency cost.

The strategy hypothesis

It is usually said the ability of an individual or corporation to freely invest in both long as well as short positions can provide managers with the best opportunity for "doubling their alpha."

The skill hypothesis

According to this hypothesis, the hedge funds will outperform the long-only mutual funds as a result of the greater flexibility of the strategy.

The regulation and incentive hypothesis

Hedge funds are noted to be suitable for retail investors as long as managers with experience are hired to run the long and short portfolios. These managers should also be provided with the necessary tools to help them succeed. According to this hypothesis, lighter regulations as well as better incentives for the hedge fund managers are very crucial determinants if the superior performance of the hedge funds.Even though hedge mutual funds employ hedge-fund-like strategies of trading, they are effectively regulated by SEC. As a consequence, these funds are faced with certain restrictions like the covering of short positions as well as the borrowing to just a third of the assets. They are crucial since they provide liquidity on a daily basis as well as audited annual reports.

In order for retail investors to benefit from the hedge funds, it is important that they possess flexibility as skill for achieving higher returns.

The reasons as to why companies shun hedge mutual funds

Several explanations exist as to why companies shun hedge mutual funds. The very first one is because the managers usually use their funds as a gateway for attracting assets to their pool of hedge funds. The second reason is that the mutual funds can effectively subsidize the mutual funds' business. The advantages of hedge funds for retail investors are;

Strong returns for the private equity over very long periods

Uncorrelated performance levels to other classes of assets

Low investment minimum relative

Good liquidity

Transparent amount exposure

Good diversification from the basket of all underlying securities

The disadvantages of hedge funds

The suitability of hedge funds for private investors is limited by the following disadvantages.

The disadvantages of hedge funds

Even though hedge funds have been regarded as return enhancers and portfolio risk diversifiers, their (Schneeweis and Spurgin,2010) the suitability for private investors is limited by the following disadvantages;

Excessive fees

The fees for maintaining hedge funds is indicated by Ineichen (2005,p.85) to be extremely high in regard to the fact that net returns is more important than the gross returns. This is due to the fact that utility is basically derived from the net returns as opposed to from the gross returns. More important are the net risk-adjusted returns.

The fees are also indicated to be small in relative to the alpha. The hedge fund fees could be high in strict absolute terms but could be low when compared to alpha.

Excessive leverage

The excessive leverage hypothesis postulates that exposure to the hedge funds is never attractive as a result of the employment of very high leverage. This is of particular concern because most financial disasters have been attributed to excessive leverage (Ineichen, 2000)

Lack of transparency

The fact that the shareholders are not granted full access to all of the information means that there is a general; lack of transparency on the activities of the hedge fund managers. This level of confidentiality emanates from the fact that the hedge funds are usually traded in short positions. The managers therefore tend to hide the specific positions from the market. There is a proposition for this disadvantage to be eliminated by a disclosure agreement on the position of the hedge funds on the basis of a time lag.

Low liquidity

Hedge funds generally have low liquidity meaning that they are more suitable for long-term investors.

Capacity restrictions / constraints

Size is usually regarded as a risk as opposed to a performance enhancing factor. This is particularly true if the assets grow very rapidly as indicated by Cottier (1996). In such conditions, niches are known to become very small thereby making it extremely difficult as well as costly to rapidly change positions so as to execute trades. Additionally, a top trader of a relatively large fund is kind of distracted by the administrative duties as well as personnel management as opposed to devoting themselves entirely to executing trades.

Hedge funds are also noted to be exposed to various kinds of risks such as political risks (this arises whenever an investment is carried out in a foreign nation as well as under restrictive laws and sovereignty of a nation. There is a risk of loss as a result of nationalization).Transfer risk ( when a foreign authority restricts the transfer and delivery of foreign currencies), settlement risks, legal risks, market risks as well as liquidity risks.

Conclusion

Hedge funds are therefore not suitable for investors because they effectively underperform other hedge funds. This fact that there are tighter constraints, stricter regulations as well as lower incentives should deter retail investors from investing in hedge funds. The disadvantages and risks associated with hedge funds makes them unsuitable investment vehicles for retail investors.