Asset management - taking a look at hedge funds and mutual funds

From the 1970s until the 2008 crash, hedge funds outperformed equities narrowly and bonds by a wider margin.

Selecting the right stocks or other financial instruments to invest in is certainly not an easy process, as it requires a good understanding of the market, extensive research and prior experience. This is where asset management can help. Essentially, it is the service of managing a person’s part of or entire investment portfolio and is usually offered by investment banks. Increasing the value of client assets over time while minimising risk is viewed as the principal objective of asset management. Asset managers are responsible for determining the appropriate portfolio structure that can yield high returns. To make the best possible decisions, they cooperate with analysts, who employ a range of macro and micro-economic tools. Examples include reviewing the financial impact of government decisions on a sector of the economy and examining a company’s past performance metrics respectively. Due to the labour costs associated with employing a team of investment experts, asset management firms typically require a high minimum investment amount. Their services are primarily targeted towards high net worth individuals, large corporations, and governments. They also charge fees for every transaction and for maintaining the portfolio, among others, which sum to a significant figure.

I'm too embarrassed to ask - what is an asset management strategy?

An asset management strategy must be tailored to the customer’s profile. An approach which reduces risk as much as possible would better suit a client investing money for retirement, while a younger high earner may prefer riskier investments that can provide higher returns. Other factors, such as what percentage should be liquid, i.e. easily convertible to cash, and tax legislation can also shape the strategy. In any case, the process begins with the client depositing a sum larger or equal to the required minimum in an asset management account. It differs from the typical high-street options, as it can be used for both regular banking and investment services. Asset managers are authorised to use the capital in the account for investment purposes. They will then decide how to allocate it between passive and active options. Purchasing index funds, such as the FTSE 100, is considered the prevalent passive approach. An index fund can be thought of as a portfolio that includes the equity of carefully chosen companies operating in a particular sector. The firms included in it must satisfy certain criteria in order to remain part of it. In contrast, the active approach refers to conducting research and selecting securities to invest in manually. Both buying and selling stocks or other instruments result in significant fees but can also render the client’s portfolio more diversified. Therefore, asset managers use a combination of both approaches and adjust them to each client’s profile.

Investors who prefer an actively managed strategy laser-focused on generating high returns will often place their money in a hedge fund. A hedge fund collects capital from a network of accredited investors, such as high net-worth individuals and banks, as it is not accessible to the wider investing public. Due to the comparatively light regulations governing their operation, hedge funds can essentially invest in all types of financial instruments and use leverage to amplify returns. Leverage refers to the strategy of borrowing money, either through a direct loan or various assets, in order to invest larger amounts in a particular stock or other security than the investor actually has. Therefore, potential returns can be multiplied, but so can losses.

Unlike hedge funds, mutual funds comprise of a pool of money gathered from several investors, without any financial criteria, for the purpose of investing in various securities, usually stocks, bonds, among others. They are managed by asset managers, who structure the fund’s portfolio in a way that reflects its stated objectives. Each participant essentially gains access to a professionally managed portfolio and accumulates gains and losses proportional to the initial amount committed.

The profitability comparison between hedge funds and mutual funds must consider several aspects, which means there is no simple answer. From the 1970s until the 2008 crash, hedge funds outperformed equities narrowly and bonds by a wider margin. Due to this observation, there exists a saying that hedge funds provide “equity-like returns with bond-like volatility”. In the post-financial crisis landscape, hedge funds have struggled to generate similar returns, often resulting in net losses. A frequently cited example is Warren buffet’s bet in 2007 on Vanguard’s S&P500 index fund outperforming the Protégé Partners LLC hedge fund by the end of 2017. The billionaire investor’s prediction proved correct, as the index fund’s profitability rose by 85% compared to Protégé Partners’ 22%, which amounts to a 286% overtake. This has led to a significant number of investors to avoid hedge funds. In 2020, hedge fund performance recovered, as the industry achieved an average return rate of 11.6%, according to Hedge Fund Research (HFR). The growth was driven by funds managing more than $5 billion, as funds with less capital experienced net losses. However, HFR projects that a portfolio tracking the S&P 500 would still have achieved higher average returns of 18.4% over the same period. In contrast, mutual funds’ performance seems closely correlated to that of an index fund. Over 10 years, research has shown that mutual funds can offer better returns than index funds, which means that they also tend to outperform hedge funds. However, the latter have demonstrated superior performance in periods of stock market bubbles bursts and downturns, such as the period 2000-2001. This is often attributed to hedge fund’s ability to employ sophisticated strategies that mutual funds are not legally permitted to use, such as short selling, which essentially allows the former to profit by betting on a stock’s value declining.

To summarise, conventional asset management has evolved to include hedge fund and mutual fund management. Their objectives involve satisfying the unaddressed needs of focusing on high risk and high reward options and providing professional portfolio management to retail investors. If performance analysis focuses on one point in time, hedge funds may yield significantly higher returns, while providing disappointing results at a different point. This leads to the poor average return rates that have been observed in the past decade. Essentially, the potential of amplified gains is associated with higher risk and constant volatility. On the other hand, mutual funds can provide more long-term stability at the expense of lower profitability and slower adjustment to changes in the market. Consequently, due to their different strategies and objectives, it is unlikely that one will consistently outperform the other in the foreseeable future.