LM03 Private Capital, Real Estate, Infrastructure, Natural Resources, and Hedge Funds

Part 1

Introduction

This learning module covers the investment characteristics of:

• Private capital
• Real Estate
• Infrastructure
• Natural Resources
• Hedge Funds

1. Private Capital

Introduction and Overview of Private Capital

Private capital is a broad term for funding provided to companies that is not sourced from the public equity or debt markets.

Capital that is provided in the form of equity investments is called private equity, whereas capital that is provided as a loan or other form of debt is called private debt.

Description of Private Equity

Private equity means investing in private companies or public companies with the intent to take them private. The companies in which the private equity funds invests are called portfolio companies because they will become part of the private equity fund portfolio.

The three main categories of private equity are:

• Leveraged buyouts: Borrowed funds are used to buy an established company.
• Venture capital: Refers to investments in companies that have not been established yet.
• Growth capital: Refers to minority equity investments in mature companies that require funds for growth or expansion, restructuring, entering a new territory, an acquisition, etc.

Leveraged Buyouts

Leveraged buyout is an acquisition of an established public or private company with borrowed funds. If the target company is a public company, then after the acquisition, the company becomes private, i.e., the target company’s equity is no longer publicly traded.

The acquisition is significantly financed through debt, hence the name leveraged buyout. LBOs capital structure consists of equity, bank debt, and high-yield bonds. The firm (GP) puts in some money of its own, raises a certain amount from LPs, and a substantial amount of money is borrowed in the form of debt to invest in companies.

For example, assume the GP invests in a target company that requires an investment of $100 million. In this, the GP invests $20 million of its money (equity), $70 million from bank debt, and the remaining $10 million is raised by issuing high-yield bonds.

There are three changes that happen to a company as a result of a leveraged buyout:

• An increase in financial leverage.
• Change in management or the way the company is run.
• If the target company is previously public, after the LBO it becomes private.

Why LBO?

• To improve the company’s operations; to add value and eventually increase cash flows and profits.
• Leverage will enhance potential returns once the restructuring/growth strategy is complete and the company turns profitable. Debt is central to an LBO structure. Buyouts are rarely done entirely using equity.

There are two types of LBOs:

• Management buyouts (MBO): Current management team purchases and runs the company.
• Management buy-ins (MBI): Current management team is replaced and the acquirer team runs the company.

Venture Capital

Venture capital firms invest in private companies (portfolio companies) with significant growth potential. The time horizon is typically long-term. The distinction between VC and LBO is that the latter invests in mature companies, whereas VC invests in growing companies with a good business plan and strong prospects for future growth.

Other important points related to VCs are given below:

• Venture capitalists are actively involved in the companies they invest in.
• The rate of return expected depends on the stage the company is in when the investment happens.
• VC investing can take place at various stages

Formative stage: Company is still being formed.

• Angel investing: Financing provided at the idea stage.
• Seed stage financing: Financing provided for product development and market research.
• Early stage: Financing for companies moving towards operation, but before commercial production and sales. Fund to initiate commercial production and sales.

Later stage financing: For expansion after commercial production and sales but before IPO.

Mezzanine stage:  Preparing to go public.

Exhibit 2 from the curriculum shows the growth stages of a company and the types of financing it may receive at each stage.

Exit Strategies

The goal of private equity is to improve new or underperforming businesses and exit them at high valuations. Typically, investments (target companies) are held for an average of 5 years. The holding period may be longer or shorter.

Common exit strategies are:

• Trade sale: Selling the company to a competitor or any strategic buyer. It can be done through auction or private negotiation. For instance, if a PE firm (GP) invested in a small generic pharma company, it may sell it to large pharma firm after a few years.
• IPO: Company goes public, i.e., it sells all or some of its shares to public investors.
• Special purpose acquisition company (SPAC): A SPAC is a shell company, often called a “blank check” company, because it exists solely for the purpose of acquiring an unspecified private company sometime in the future. SPACs raise capital through IPOs and deposit the proceeds in a trust account. They have a finite time (e.g. 24 months) to complete a deal; otherwise, the proceeds are returned back to the investors.
• Recapitalization: The PE firm increases leverage or introduces it to the portfolio company and pays itself a dividend out of the new capital structure. Not a true exit strategy, as the PE firm still maintains control, but it does allow the PE firm to extract money from the company.
• Secondary sale: Assume you are a VC firm that focuses on early-stage companies. You may sell the portfolio company later to another private equity firm that focuses on later stage companies.
• Write off/liquidation: This is a worst-case scenario when the investment has not gone as planned. The company’s prospects do not look promising, so the VC firm sells the assets or writes it off to focus on other projects.

Description of Private Debt

Private debt refers to various forms of debt provided by investors to private entities.

Key private debt strategies include:

• Direct lending: Debt capital is provided at higher interest rates, directly to entities that require capital, but are unable to get capital from traditional bank lenders. Lenders subsequently receive interest, the original principal, and possibly other payments in exchange for their investment.
• Mezzanine debt: Refers to private credit that is subordinated to senior secured debt but is senior to equity in the borrower’s capital structure. Because of the higher risk, investors commonly demand a higher interest rate and may also require options for equity participation.
• Venture debt: Debt funding provided to start-up or early-stage companies that may be generating little or negative cash flow. Entrepreneurs may seek venture debt as a way to access funds without further diluting shareholder ownership in their companies. Similar to mezzanine debt, venture debt may contain additional feature that compensate investors for the increased risk.
• Distressed debt: Refers to buying debt of mature companies with financial difficulty such a bankruptcy proceeding. Investors seek companies with a temporary cash-flow problem but a good business plan. They may also get actively involved in the management of the company and help turn it around.

Risk and Return Characteristics of Private Capital

Risk/Return of Private Equity

Private equity may provide higher return opportunities relative to traditional investments. Some of its benefits include the following:

• Access to private companies.
• Ability to actively manage and improve portfolio companies.
• Easy to use leverage.

However, the higher return is often associated with higher illiquidity and leverage risks.

Risk/Return of Private Debt

Private debt investments can provide a higher return as compared to traditional bonds. However, this higher return if often connected to higher levels of risk.

Diversification Benefits of Private Capital

Investing in private capital can provide moderate diversification benefits because of their low correlation to stocks and bonds. Investors should identify and invest in the best performing private equity funds.

2. Real Estate

Introduction and Overview of Real Estate

Real estate has two major sectors:

• Residential: Includes individual single-family detached homes and multi-family attached units owned by the residents. Residential real estate is the largest sector, making up some 75% of the market globally.
• Commercial: Commercial real estate primarily includes office buildings, shopping centers, and warehouses. When residential real estate properties (described above) are owned with the intent to rent, they are classified as commercial real estate.

The key reasons for investing in real estate are:

• Potential for competitive long-term returns (income and capital appreciation).
• Rent for long-term leases will lessen the impact of economic shocks.
• Diversification because of low correlation with other asset classes such as stocks, bonds.
• Inflation hedge.

A title or deed represents ownership of real estate property, including building and land-use rights, as well as air, mineral, and surface rights. Titles can be purchased, leased, sold, mortgaged, or transferred. A title search is an important part of buyer and lender due diligence because it ensures the seller/borrower owns the property free and clear of any liens or other claims against it, such as those from other owners, lenders, or investors, or from the government for unpaid taxes.

Investment characteristics of real estate are as follows:

• Indivisibility – requires large capital investments
• Illiquidity
• Unique characteristics (no two properties are identical).
• Fixed location.
• Requires professional operational management.
• Local markets can be very different from national or global markets.

Description of Real Estate

Residential Property

• Properties such as residences, apartment buildings, and vacation homes, purchased with the intent to occupy.
• Most home buyers cannot fund the home entirely with cash. Instead, it is leveraged equity, i.e., they borrow money (loan/mortgage) to make the purchase.
• Most lenders require an equity contribution of at least 10% – 20% of the property purchase price.

Commercial Property

• Preferred by investors (both institutional and HNIs) with limited liquidity needs and long time horizons.
• Primarily comprises office buildings purchased with the intent to rent.
• Direct investment: can be equity or debt financed.
• Debt financing: lender must ensure the borrower is credit worthy. The property must generate enough cash flows through rent to service the debt. How much loan the borrower can get (loan-to-value ratio) depends on the value of the property.
• Equity investing: Requires active and experienced management.

REITs

• Real estate investment trusts (REITs)are tax-advantaged entities (companies or trusts) that own, operate, and—to a limited extent—develop income-producing real estate property
• Risk and return characteristics depend on the type of investments made.
• Mortgage REITs are similar to fixed-income investments.
• Equity REITs are similar to direct equity investments in leveraged real estate.

Mortgage-Backed Securities

• An MBS issuer forms a special purpose vehicle (SPV) to buy mortgages from lenders and uses them to create a diversified mortgage pool.
• Tranches of the SPV are sold to investors who receive the incoming stream of mortgage payments associated with their tranche.
• Different tranches have a different priority distribution ranking of incoming cash flows. Risk averse investors prefer the lowest-risk tranches, which are the first to receive interest and principal payments, but they also offer the lowest returns. Highest-risk tranches are the last to receive interest and principal payments, but they offer the highest return.

Forms of Real Estate Investing

Real estate investing can be categorized along two dimensions: public/private markets and debt/equity based.  Exhibit 9 presents the four quadrants for the basic forms of real estate investments with examples:

Basic forms of real estate investments and examples

Equity-based investments represent ownership of real estate properties.  Ownership can be through sole ownership, joint ventures, real estate limited partnerships, etc. A variation of equity-based investments is leveraged ownership: Assume a building costs $10 million, and you put $3 million of your money and borrow $7 million. This is called leveraged ownership. That is, leveraged ownership is where a property is obtained through equity and mortgage financing.

If you are investing in a debt-based real estate investment, it means you are lending money to a purchaser of real estate. A classic example is a mortgage loan.  This is considered a real estate investment because the value of the mortgage loan is related to the value of the underlying property.

There can be many variations within the basic forms:

• Direct real estate investing: Involves purchasing a property and originating debt for one’s own account. The major advantages are: control, and tax benefits. The major disadvantages are: extensive time and expertise required to manage the property, the large capital requirements, and highly concentrated portfolios.
• Indirect real estate investing: Pooled investment vehicles are used to access the underlying real estate assets. The vehicles can be public or private, such as limited partnerships, mutual funds, corporate shares, REITs, and ETFs.
• Mortgages: Represent passive investments in which the lender can expect to receive a predefined stream of payments over the life of the mortgage.
• Private fund investing styles: Most real estate private equity funds are structured as infinite-life open-end funds, which allow investors to contribute or redeem capital throughout the life of the fund.
• REITs: REITs combine the features of mutual funds and real estate. An REIT is a company that owns income-producing real estate assets. In REITs, average investors pool their capital to invest (take ownership) in several large-scale, diversified income-generating real estate properties. The REIT issues shares, where each share represents a percentage ownership in the underlying property. The income generated is paid as a dividend to the shareholders.

The main advantage of the REIT structure is that it avoids double corporate taxation. Normal corporations pay taxes on income, and then the dividend paid from the after-tax earnings are taxed again at the shareholder’s personal tax rate. REITs can avoid corporate income taxes by distributing 90% – 100% of their rental income as dividends.

The value of the REIT shares is based on the dividend. REIT shares often trade publicly on exchanges. It is a way for individual investors to earn a share of the income from commercial properties (office buildings, warehouses, and shopping malls) without buying them. Risk and return of REITs vary based on the types of properties they invest in. Equity REITs invest primarily in residential and commercial properties.

Risk and Return Characteristics of Real Estate

Real Estate Indexes

There are a number of indexes to measure real estate returns that vary based on the underlying constituents and longevity.

• REIT Index: It is constructed using the prices of publicly traded shares of REITs to construct the indices. The accuracy of the index depends on how frequently the shares of the index trade.
• Appraisal Based Index: Often actual transaction prices are not used by private real estate indexes because real estate assets do not transact very often and managers do not take the effort to revalue property. The drawbacks are: the appraisals are backward looking, they are subject to the biases of the appraisers, and they smooth-out volatility.
• Repeat Sales Index: These indexes are transaction based rather than appraisal based. Repeat sales of properties are used to construct the indices; i.e., the change in the price of the same properties is measured in this method. These indexes suffer from sample selection bias because it is highly unlikely that the same properties come up for repeat sales every year.

Real Estate Investment Risks

Like any investment, real estate investing has its risks if the outcome does not turn out to be as per expectations.

• Property values are subject to variability based on national and global economic conditions, local real estate conditions (more supply than demand or demand more than supply), and interest rate levels.
• Ability to select, finance, and manage real estate properties. This includes collecting rent, maintenance, undertaking repairs on time, and finally disposing the property. Economic conditions may be different when the property was bought and when it is sold.
• Expenses may increase unexpectedly.
• Leverage magnifies risks to equity and debt investors.

Diversification Benefits of Real Estate

Many investors prefer real estate for its ability to provide high, steady current income. Real estate also has moderate correlation with other asset classes and thus provides some diversification benefits. However, there are periods when equity REIT correlations with other securities are high, and their correlations are highest during steep market downturns.

3. Infrastructure

Introduction and Overview of Infrastructure

The assets underlying infrastructure investments are real, capital intensive, and long-lived. These assets are intended for public use, and they provide essential services e.g., airports, health care facilities, and power plants.

Infrastructure assets were primarily owned, financed, and operated by the government. Of late, they are financed privately through the use of public-private partnerships (PPPs). The provider of the assets and services has a competitive advantage as the barriers to entry are high due to high costs and regulation.

Investors invest in infrastructure assets because:

• The assets can generate stable long-term cash flows that adjust for economic growth and inflation.
• High levels of leverage can be used to acquire these assets which has a potential to enhance investor returns.
• The assets can help incorporate ESG criteria, e.g., investments in renewable energy sources.

Description of Infrastructure

Categories of Infrastructure Investments

Infrastructure investments may be categorized based on: (1) underlying assets, (2) stage of development of the underlying assets, and (3) geographical location of the underlying assets. Let us look at the various sub-categories now.

Infrastructure investments based on underlying assets: They can be classified into economic and social infrastructure assets.

• Economic infrastructure assets: These include transportation, communication, and social utility assets that are needed to support economic activity. Examples of transportation assets are roads, airports, bridges, tunnels, ports, etc. Examples of utility assets are assets used to transmit and distribute gas, electricity, generate power, etc. Examples of communication assets are assets that are used to broadcast information.
• Social infrastructure assets: These are assets required for the benefit of the society such as educational and healthcare facilities.

Infrastructure investments based on the stage of development of the underlying assets: They can be classified into brownfield and greenfield investments.

• Brownfield investments: These are investments in existing investable infrastructure assets. These may be assets, with a financial and operating history, which the government wants to privatize.
• Greenfield investments: These are investments in yet-to-be-constructed infrastructure assets. The objective may be to construct and sell the assets to the government, or to hold and operate the assets.

Infrastructure assets may also be categorized based on their geographical location.

Forms of Infrastructure Investments

Investors may invest either directly or indirectly in infrastructure investments. The investment form affects the liquidity and the income and cash flows to the investor.

The advantages of investing directly in infrastructure are that investors have a control over the asset and can capture the full value of the asset. But the downside of a large investment is that it results in concentration and liquidity risks.

Most investors invest indirectly. Some forms of indirect investments include:

• investment in an infrastructure fund
• infrastructure ETFs
• shares of companies

Investing in publicly traded infrastructure companies offer the benefit of liquidity. Publicly traded infrastructure securities also have a reasonable fee structure, transparent governance, and provide the benefit of diversification. Master limited partnerships (MLPs) are pass-through entities similar to REITs and are listed on exchanges.

Risk and Return Characteristics of Infrastructure

Infrastructure investments with the lowest risk have stable cash flows and higher dividend payout ratios, but they also have lower expected returns and lesser growth opportunities. An example of a low-risk infrastructure investment is toll roads. An example of a high-risk infrastructure investment is a fund building a new power plant (a greenfield investment).

Some of the risks associated with infrastructure investments include:

• Revenues being different than expected.
• Leverage creates financial and operational risk.
• Construction risk.
• Regulatory risk

Exhibit 17 from the curriculum shows the typical risk management considerations for various risks of infrastructure investments.

Diversification Benefits of Infrastructure

Some of the advantages to investors from investing in infrastructure are as follows:

• a steady income stream
• potential for capital appreciation
• diversification because of low correlation of infrastructure assets to traditional investments
• protection against inflation
• match the long-term liability structure of some investors such as pension funds

4. Natural Resources

Introduction and Overview of Natural Resources

Natural resources include:

• Commodities: Can be further classified into:
  • Hard: Commodities that are mined e.g., copper, gold, silver; and commodities that are extracted e.g., crude oil, natural gas.
  • Soft: Commodities that are grown over a period of time e.g., grains, livestock, and cash crops like coffee.
• Agricultural land (or farmland):
  • Investments in land used for the cultivation of crops or livestock.
  • Income can be generated from the growth, harvest and sale of crops or livestock; or by leasing the land back to farmers.
• Timberland:
  • Investments in natural forests or managed tree plantations.
  • The return comes from the sale of trees, wood, and other timber products.

Up to about 20 years ago, investors looking for exposure to natural resources invested mainly via financial instruments (stocks and bonds). Instead of investing in the physical land and the products that come from it, investors focused on the companies that produced natural resources. Nowadays, however, due to the wide variety of direct investments available (ETFs, limited partnerships, REITS, swaps, and futures), investors typically participate in these assets directly.

Description of Commodities

Commodities are physical products that can be standardized on quality, location, and delivery for investment purposes.

Generally, commodity investments take place through derivative instruments, because of the high storage and transportation costs incurred when holding commodities physically. The underlying asset of a commodity derivative may be a single commodity or an index of commodities. The return on commodity investment is based mainly on price changes rather than an income stream such as dividends.

In order to be transparent, investable, and replicable, commodity indexes typically use the price of the futures contracts rather than the prices of the underlying physical commodities.

Commodity sectors include:

• Energy – oil, natural gas, coal, electricity etc.
• Base metals – copper, aluminum, zinc etc.
• Precious metals – gold, silver, platinum etc.
• Agriculture – grains, livestock, coffee etc.
• Others – carbon credits, freight, forest products etc.

How are commodity futures contracts priced?

• The price of a futures contract can be calculated using the following formula:

Future price ≈ Spot price (1 + r) + Storage costs – Convenience yield

where: convenience yield is the value associated with holding the physical asset;

r is the short-term risk-free interest rate

• Future prices may be higher or lower than spot prices, based on convenience yield.
• For no arbitrage to occur, Future price ≈ Spot price (1+r). But commodities incur storage costs. So, they must be added to the future price and we get Future price ≈ Spot price (1 + r) + storage costs. Storage and interest costs are collectively known as “cost of carry”.
• Why subtract the convenience yield? Because the buyer does not possess the commodity as of now, until the end of the contract. Since he has given up this convenience, it must be subtracted from the future price. That’s how we arrive at Future price ≈ Spot price (1 + r) + storage costs – convenience yield
• Futures price may be higher or lower than the spot price based on the convenience yield.

Contango: Future price > Spot price Markets tend to be in contango when there is little or no convenience yield.

Backwardation: Future price < Spot price Markets tend to be in backwardation when the convenience yield is high

Digital Commodities:

Digital assets can be thought of as anything that can be stored and transmitted electronically and has associated ownership or use rights. Digital assets may take many forms (such as digital tokens and virtual currencies) and may utilize various underlying technologies, including distributed ledger technology (DLT).

Forms of Commodity Investments

Commodity investments are typically made through derivatives as the storage and transportation costs for holding physical commodities are significant. Commodity derivative contracts may trade on exchanges or over the counter. The popular derivatives include futures, forwards, options,  and swaps.

Commodity exposure can also be achieved through:

• Exchange traded products (either funds or notes).
• Managed futures (also known as CTAs)
• Funds that specialize in specific commodity sectors e.g., private energy partnerships are similar to PE funds and can be used to gain exposure to the energy sector.

Description of Timberland and Farmland

Timberland

Timberland provides an income stream through the sale of trees, wood, and other timber products. Timberland can be thought of as both a factory and a warehouse. The trees can be easily stored by simply not harvesting them. The trees can be harvested based on the price: more harvest when prices are up and delayed harvest when prices are down.

The three return drivers for timberland investments include: biological growth, change in prices of lumber (cut wood), and underlying land price change.

Additionally, since trees consume carbon as part of their life cycle, timberland considered a sustainable investment that mitigates climate-related risks.

Farmland

Farmland is perceived to provide a hedge against inflation. Two types of farm crops include raw crops that are planted and harvested, and permanent crops that grow on trees. Like timberland, farmland also provides an income component related to harvest quantities and agricultural commodity prices. However, it does not provide production flexibility, as farm products must be harvested when ripe.

Similar to timber land, the return drivers for farmland are: harvested quantities, commodity prices, and land price appreciation.

Forms of Timberland and Farmland Investments

The primary investment vehicles for timberland and farmland are investment funds. These funds could be offered publicly via REITs or privately via limited partnerships.

Large investors can also consider direct investments in these assets.

Risk and Return Characteristics of Natural Resources

Risk/Return: Commodities

Commodities offer potential for returns, portfolio diversification, and inflation protection.

Commodity spot prices are a function of supply and demand, the costs of production and storage, value to users, and global economic conditions.

• Supplies of commodities depend on production and inventory levels.
• Demand of commodities depends on the consumption needs of end users.
• Demand may be high while supply may be low during economic growth; conversely, demand may be low and supply high during times of economic slowdown.
• If demand changes very quickly during any period, resulting in supply-demand mismatch, it may lead to price volatility.

Risk/Return: Timberland and farmland

Timberland and farmland investments have similar risks as other real estate investments in raw land. However, weather is major risk factor for these investments. Bad weather conditions can drastically reduce harvest yields.

Another important risk factor is the international competitive landscape. Unlike other real estate that is mainly impacted by local factors, timberland and farmland produce commodities that are globally traded; therefore, they are impacted by global factors.

Diversification Benefits of Natural Resources

Diversification Benefits: Commodities

Commodities are attractive to investors not only for the potential profits but also because:

• They provide a good inflation hedge. Some commodity prices are a component of inflation calculations e.g., food and energy.
• They provide effective portfolio diversification. Historically, the correlation between commodities and traditional investments has been low.

Diversification benefits: Timberland and farmland

ESG investors looking for responsible and sustainable investing can include timberland and farmland in their portfolios. These investments can help mitigate climate change.

Timberland and farmland have also exhibited low correlation with traditional investments. Thus, they can provide effective diversification benefits.

5. Hedge Funds

Introduction and Overview of Hedge Funds

History: Hedge funds were originally started in 1949 as a way to hedge long-only stock portfolio. These funds followed three key principles:

• Always maintain short positions.
• Always use leverage.
• Only charge an incentive fee of 20% of the profits with no fixed fees.

Over time, the principles have changed. The following are the characteristics of hedge funds today:

• Aggressively managed portfolios of investments across asset classes and regions, use leverage, take long/short positions, and/or use derivatives.
• Generate high returns: either absolute or over a specified benchmark with minimal restrictions.
• Set up a private investment partnership with a limited number of investors who are willing to make a large initial investment.
• Investors are required to keep the money with the fund for a certain period – lockup period. Redemptions are not immediate. Usually, require a minimum notice period of 30 to 90 days.
• Invest anywhere there is a high return opportunity as restrictions are less.

Description of Hedge Funds

There are several hedge fund strategies. These fall in four major categories:

• Event-driven: A short term, bottom-up strategy that aims to profit from pricing inefficiencies before a major potential corporate event. Ex: bankruptcy, acquisition, merger, restructuring of a company, asset sale (large pocket of land in a prime location).
• Relative value: A strategy that seeks to profit from price discrepancy between related securities such as stocks and bonds.
• Macro: Uses a top-down approach to identify trends based on changes in economic policies across the globe. The strategies could focus on currency markets, fixed income markets, or based on changes in interest rates. Trades are based on expected movement in economic variables.
• Equity hedge: Bottom-up strategy. Not focused on event-driven or macro strategies. Take long and short positions in publicly traded equity/equity derivative securities.

The sub-classifications under each category are listed below:

Forms of Hedge Fund Investments

Selecting and investing in an individual hedge fund can be difficult because of the extensive due diligence required and the high minimum investment threshold. Therefore, some investors may prefer to invest in a fund of hedge funds.

A diversified portfolio of hedge funds is often referred to as a fund of funds. This instrument makes hedge funds accessible to smaller investors or to those who do not have the resources, time, or expertise to choose among hedge fund managers. Other benefits include:

• Better redemption terms
• Due diligence expertise
• More diversification as they invest in hedge funds across geographies and strategies

However, fund of funds may charge an additional 1% management fee and 10% incentive fee on top of the fees charged by the underlying hedge funds. This double layer of fees can significantly reduce the after fee returns to the investor.

Risk and Return Characteristics of Hedge Funds

Hedge fund indexes suffer from self-reporting and survivorship biases. Historically, hedge funds have provided higher returns than either stocks or bonds with a relatively low standard deviation. They have certainly added value to institutional investors as a portfolio diversifier.

Diversification Benefits of Hedge Funds

Due to different strategies across hedge funds, the diversification benefits associated with every hedge fund is not necessarily meaningful. It is believed that less-than-perfect correlation of hedge funds with stocks provides diversification benefit. However, during financial crisis periods, the correlation between hedge fund performance and stock market performance may increase.

Between 2009 – 2019, most hedge funds failed to beat the performance of equity and bonds. But they still continue to be a part of institutional asset allocations because of their risk-diversification properties.

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