Hedge funds have evolved since their introduction in 1949. They spread from the United States to Europe, Asia, and the emerging markets. While technical definitions vary across borders, in general, hedge funds are actively managed pools that follow less-conventional investment strategies. They are usually unregistered investment vehicles intended for sophisticated institutional investors and wealthy individuals. In the strictest sense, hedge funds are not an asset class, but rather an amalgam of strategies that invest across asset classes. The term “hedge fund” itself functions as a catchall phrase for private investment partnerships, regardless of whether hedging techniques are actually employed. Like traditional investment managers, hedge funds manage portfolios of securities, have predetermined investment objectives and styles, and employ strategies ranging from conservative to the extremely aggressive. Hedge funds can engage in a variety of investment strategies that include leverage, derivatives trading, and short selling. Unlike traditional active managers, who seek to outperform benchmarks on a relative basis, hedge funds often target positive absolute returns regardless of market direction.
Industry Growth and Asset Accumulation
Record-Breaking Asset Levels
The hedge fund industry has achieved remarkable growth milestones through 2025, with total global assets under management reaching an estimated $4.51 trillion by the end of 2024, marking the fifth consecutive quarterly record. This represents an extraordinary increase of $401.4 billion for the full year 2024, driven primarily by strong performance gains rather than net inflows. The industry experienced its best year for asset growth in recent times, with performance contributing approximately $391 billion to the total increase while net flows remained modest at $10.47 billion.
The concentration of assets among the largest firms has intensified significantly. The top 533 firms managing more than $1 billion in hedge fund assets now control approximately $3.35 trillion, representing about 82% of total industry assets. This concentration has created a "Billion Dollar Club" that dominates the landscape, with 79 firms now managing more than $10 billion each, compared to 70 firms at the end of 2023. The largest firms continue to capture a disproportionate share of new assets, with firms managing greater than $5 billion experiencing estimated inflows of $9.4 billion for the full year 2024.
Geographic Distribution and Market Dominance
North American hedge funds have strengthened their dominance over the global industry, now managing approximately $3.95 trillion, or about 81% of global assets as of September 2024. This represents a continued drift toward U.S.-based concentration that has accelerated over the past decade. Europe maintains its position as the second-largest region with $746.6 billion in assets, representing 15.3% of global hedge fund capital. The geographic concentration reflects both the depth of U.S. capital markets and the regulatory environment that has favored American hedge fund growth.
The largest individual hedge funds have evolved into massive financial institutions. Bridgewater Associates, while maintaining its position as the world's largest hedge fund manager, has seen its assets decline below $100 billion for the first time in years due to client withdrawals, despite strong performance from its flagship strategies. Citadel, Millennium Management, and Elliott Investment Management have emerged as dominant forces, with several firms now managing between $60-90 billion in assets.
The Evolution of Hedge Funds
Alfred Winslow Jones created the first hedge fund in 1949 and is widely regarded as the father of the modern hedge fund industry. Jones’ inspiration was to combine speculative tools to create what he considered a more conservative or “hedged” investment strategy. He used leverage to buy more shares, but also employed short selling to reduce exposure to market risk. He bought as many stocks as he sold short, so overall market moves up or down offset each other. His objective was to render the overall market’s direction irrelevant and generate positive returns by buying and shorting the right stocks.
Jones’ pioneering fund avoided the requirements of The Investment Company Act of 1940 by restricting itself to 99 investors in a limited partnership structure and charged a 20 percent incentive fee on gains. However, unlike most modern hedge funds, fees were not levied unless the fund actually profited. The private partnership structure, the incentive fee, and the blending of long and short positions remain core elements of the hedge fund industry today.
Hedge funds spent the 30 years between 1950 and 1980 in relative obscurity. However, by the mid-1980s, long-short equity and global macro managers dominated the landscape as hedge fund legends Julian Robertson, George Soros, and others grabbed headlines in the financial press. Media attention deified such managers and drove many wealthy investors to seek out hedge funds for the first time. Hedge fund investing became the topic of boastful high society cocktail party chatter.
The industry’s growth accelerated considerably in the 1990s. In 1992, George Soros made a famous (and massively profitable short bet) on the British pound that “broke the Bank of England.” Long Term Capital Management’s infamous and systemically hazardous implosion in 1998 grabbed the spotlight. According to Hedge Fund Research, hedge fund assets grew from $39 billion in 1990 to $539 billion by 2001. Over the same period, the total number of hedge funds increased more than sevenfold from 610 to 4,454.
The first decade of the twenty-first century was eventful for hedge funds. As of early 2025, there are an estimated 30,000+ active hedge funds in the market. Today’s hedge fund landscape is crowded with new specialized strategies sprouting up seemingly overnight.
Modern Hedge Fund Strategies
The hedge fund landscape can be broadly categorized. As of 2025, Hedge Fund Research (HFR) classifies hedge funds primarily into the following broad categories: Equity Hedge, Event-Driven, Macro, Relative Value, Multi-Strategy, and Fund of Hedge Funds. Each category is composed of several underlying strategies with varying sub-styles, and many of these strategies and nuanced sub-styles often overlap. Additionally, there has been a significant expansion and increased focus on specialized sub-strategies within the Cryptocurrency and Blockchain space, reflecting evolving market opportunities and investor interest.
Equity Hedge
Equity hedge managers maintain long and short positions primarily in equity and derivative securities. Portfolio selection can be driven by either quantitative or fundamental strategies. Strategies can be broad (global) or narrow (sector specific) and have ranges of net exposures, leverage, holding periods, and concentrations to various market capitalizations.
The equity hedge category has several sub-strategies:
- Market neutral managers often use quantitative techniques to build long-short portfolios, but maintain little directional exposure to the market.
- Quantitative directional managers are similar to market neutral managers, but they have greater leeway to maintain directional market exposure.
- Fundamental growth and value managers follow stock selection processes similar to traditional growth and value managers, but can also employ leverage and short-selling.
- Sector specialists concentrate on specific sectors (e.g., healthcare, technology, energy, etc.), but usually maintain net positive market exposure to their sectors.
- Short-biased strategies are similar to traditional long-short, but typically maintain varying levels of net short exposure.
- Multi-strategy equity hedged managers employ multiple hedged equity strategies within a single portfolio.
Event-Driven
Event-driven managers take positions in companies involved in corporate transactions such as mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance, or other capital structure events. Security types can range from senior to junior in the capital structure. Such managers frequently use derivatives. Their investment theses are typically fundamentally driven.
The event-driven category has several sub-strategies:
- Activist managers seek to gain control to change management or the strategic direction of a company, ostensibly to maximize shareholder value.
- Credit arbitrage managers seek to exploit mispricing among debt securities of an issuer.
- Distressed managers seek to profit from purchasing deeply discounted credit securities or instruments as a result of a company’s actual or impending bankruptcy.
- Merger arbitrage managers seek opportunities in equity and equity-related instruments of companies engaged in ownership transactions.
- Private issue strategies buy equity and equity-related instruments that are primarily private or illiquid securities of companies.
- Special situation managers focus on opportunities in equity and equity related instruments of companies which are engaged in a corporate transaction, security issuance/repurchase, asset sales, division spin-off, or other catalysts.
- Multi-strategy event-driven managers employ multiple event-driven strategies within a single portfolio.
Macro
Macro managers take an over-arching economic world view. They engage in strategies where economic change impacts equity, fixed-income, currency, and commodities markets.
The macro category has several sub-strategies:
- Active trading strategies employ either discretionary or rules-based high-frequency trading in multiple asset classes.
- Single commodity managers trade a single commodity type (e.g., metals, energy, agriculture) using a fundamental, systematic, or technical process.
- Multi-commodity managers include both discretionary and systematic commodity strategies. Systematic means that mathematical, algorithmic, and technical models drive portfolio positioning. The systematic commodity trading strategies are often used by Commodity Trading Advisors (CTAs). Discretionary commodity strategies rely on fundamental evaluation of markets, relationships, and influences as they relate to commodity markets.
- Currency discretionary strategies rely on fundamental evaluation of market data to trade currency markets. They generally use top-down macroeconomic analysis of variables.
- Currency systematic strategies are driven by mathematical, algorithmic, and technical models.
- Discretionary thematic strategies trade in equity, interest rates, fixed-income, currency, and commodity markets. They rely on the evaluation of market relationships and influences and a top-down analysis of macroeconomic variables.
- Systematic diversified strategies trade multiple asset classes and are driven by mathematical, algorithmic, and technical models.
- Multi-strategy macro managers employ a variety of macro strategies within a single portfolio.
Relative Value
Relative value managers seek to exploit value discrepancies between securities. They employ a variety of fundamental and quantitative techniques to develop investment theses. They trade equities, fixed income, convertible bonds, and derivatives.
The relative value category has several sub-strategies:
- Fixed-income–asset backed strategies seek to exploit mispriced spread relationships between related fixed-income instruments backed by physical collateral or other financial obligations (i.e., loans, mortgages, credit cards, etc.).
- Fixed-income convertible arbitrage strategies seek to exploit mispricing between a convertible bond and the stock of the issuer. They also may arbitrage spreads between other related instruments.
- Fixed-income corporate strategies seek to exploit the spread between multiple related corporate fixed-income instruments. Fixed-income-corporate strategies differ from event-driven credit arbitrage in that the former uses general market hedges. Event-driven credit arbitrage typically has little or no net credit market exposure.
- Fixed-income–sovereign strategies seek to exploit spreads between a sovereign fixed-income instrument (foreign government bond) and some related instrument (a corporate bond or a derivative contract).
- Volatility strategies trade implied volatility as an asset class. They use derivative instruments such as options and swaps on the volatility index (VIX) or some other measure of volatility. Volatility exposures can be long, short, neutral, or variable to the direction of implied volatility.
- Yield alternatives–energy infrastructure strategies seek to exploit valuation discrepancies between master limited partnerships (MLPs), utilities, or power generators. They typically use fundamental analysis.
- Alternatives–Real Estate strategies seek to exploit the valuation differences between related instruments with exposure to real estate. Strategies are typically fundamentally driven.
- Multi-Strategy relative value seeks to arbitrage spread relationships among any of the above.
Multi-Strategy
A multi-strategy hedge fund allocates capital opportunistically among various strategies and styles. “Multi-strat” managers typically lever the whole portfolio. Total portfolio assets back the obligations of each specific underlying leveraged position. There is an important difference between single multi-strategy managers and multi-strategy fund of funds. Cross collateralization within a single multi-strat manager theoretically allows one errant highly levered strategy or trade to bring down the entire portfolio. A multi-strategy fund of hedge funds allocates capital to several hedge fund firms so this cross collateralization does not occur.
Performance Trends and Strategy Evolution
Strong Performance Recovery
The hedge fund industry delivered strong performance in 2024, with the HFRI Fund Weighted Composite Index advancing 9.8% for the year, marking its strongest performance in over a decade. This performance was broad-based across strategies, with equity hedge strategies leading the way at 12.0% returns, followed by event-driven strategies at 11.6%. Multi-strategy funds, which have become increasingly popular among institutional investors, generated returns of 13.6% in 2024, representing a significant improvement from their prior-year ranking among strategies.
The performance success in 2024 was driven by several factors that have created a more favorable environment for hedge fund alpha generation. Increased market dispersion at the security, sector, and country levels has provided abundant opportunities for skilled managers to generate returns through stock selection and relative value trades. The normalization of interest rates has particularly benefited strategies with meaningful cash holdings, as market-neutral, long/short equity, and arbitrage strategies now generate attractive short-interest rebates that provide a buffer to returns.
A foundational concept in evaluating manager skill is the Jones Model. This model posits that a portfolio's total return can be decomposed into two key components: beta, which represents the portion of returns attributable to general market movements (i.e., systematic risk that cannot be diversified away), and alpha, which is the excess return generated by the manager's unique abilities, such as superior stock picking, market timing, or arbitrage. In essence, alpha is the measure of a manager's true value-add, independent of broad market performance. The relentless pursuit and consistent generation of alpha, as defined by models like Jones', remain central to the hedge fund industry's value proposition for sophisticated investors seeking returns beyond passive market exposure.
Hedge Fund Terms and Structures
The most common structures used for hedge funds are limited partnerships (LP) and limited liability companies (LLC). Both structures limit the liability of investors to the value of their investments. Within the LP structure, the general partner is typically the hedge fund manager while the investors are the limited partners. All owners of an LLC are referred to as members; the investment manager is usually the managing member.
Due to tax considerations, hedge funds are structured either as offshore or onshore funds. Onshore funds may be more suitable for U.S. taxpayers as offshore funds raise complex tax issues. Investing in an offshore fund can be advantageous for tax-exempt U.S. investors because hedge fund leverage can create “unrelated business taxable income” or UBTI. UBTI is taxable even to tax-exempt investors. Offshore hedge fund investors must also make sure the hedge fund structure blocks UBTI. Blocking of UBTI is usually accomplished through a master-feeder structure.
Unlike 1940 Act mutual funds, hedge funds have complicated expense structures. Fees are higher than typical mutual funds, and the general partner (or equivalent) normally shares in profits. However, there are also several less publicized and often meaningful costs born by investors, including research, trading, legal, auditing, and administration expenses. Management fees are meant to cover the manager’s operating costs and typically range from 1 to 2 percent of the fund’s net asset value (NAV), but can be higher depending on the fund and strategy. Recently, some managers have reduced their fees, particularly if that manager has created a new fund or a share class with more restrictive liquidity terms. However, most pedigreed managers operating at or near capacity are unlikely to reduce fees, and some have actually increased them. Most hedge funds charge a performance fee. Performance fees are calculated as a percentage of the fund’s profits over a pre-determined period. Performance fees are customarily 20 percent of the profit, but can range from 0 to 50 percent. Some managers have been pressured into marginally lowering performance fees; that is less common than reductions in management fees.
Most hedge funds must beat a high water mark or a previously achieved threshold before they can collect a performance fee; this prevents managers from collecting a performance fee until investors recoup previous losses. This is also sometimes referred to as a “loss carry-forward.” Some managers charge redemption fees if investors make withdrawals before a stated predetermined time period.
Hedge funds are typically open-ended vehicles, meaning investors contribute and redeem capital at net asset value on a periodic basis. Most funds allow for contributions at least as often as redemptions. Liquidity terms range from monthly to annually depending on strategy and manager preference. In order to minimize strategy disruption, most managers require notification for contributions or redemptions anywhere from 30 to 100 days in advance of the next liquidity window.
Hedge fund managers often have initial lock-up periods. This lock-up can be specific to each individual contribution or just the initial investment. The lock-up periods vary by manager and strategy, but usually range from one to three years. Funds also can have redemption gates that limit the amount of capital that can be withdrawn on the fund’s scheduled redemption date. Gates can be used to delay or suspend withdrawals in order to prevent a run on the fund’s capital. During the 2008 financial crisis, many managers imposed gates to the great dismay of investors. However, managers are moving away from portfolio-level gates and towards investor-level gates, which allow investors to redeem a portion of their assets even under the worst case scenarios.
Why Invest in Hedge Funds?
Why on earth would endowments and foundations want to expose their portfolios to the baffling complexity of hedge funds? Unfortunately, many endowments and foundations invest in hedge funds for reasons that are neither rational nor helpful. A common, and poor, rationale is “Because Harvard and Yale do it.” These high-profile institutions have well-trained armies of employees and consultants to vet strategies and managers for the portfolio. Investing in hedge funds without the proper skill and resources is a recipe for disaster. The needed skills and resources are expensive and require significant scale to be cost effective. Depending on the manager and strategy, comprehensive due diligence can cost $50,000 per manager and take several months. A related poor rationale is that hedge funds provide a panacea for dealing with other investment risks. Hedge funds have significant specialized investment risks despite what you might hear from a highly skilled (and incented) hedge fund salesperson.
There are really only two rational reasons to invest in hedge funds. First, you think doing so will improve the risk-adjusted performance of your aggregate portfolio. Second, and significantly more importantly, you believe you can do it well. If you can’t clear these two hurdles, you would be wise to forgo hedge funds and focus your attention elsewhere.
An investor’s objective when investing in hedge funds, or any other investment, should be to improve risk-adjusted performance. That can either mean increasing expected return without increasing expected risk or reducing expected risk without decreasing expected return.
Alpha-Beta Framework, Hedge Funds, and Fees
The alpha-beta divide is a confusing and often misconstrued concept. It seems simple; “beta is risk” and “alpha is skill.” The term beta, (derived from the Capital Asset Pricing Model [CAPM]), describes the component of an investment’s total return that is explained by its exposure to a market (systematic) risk factor. For example, if a large-cap stock portfolio has a beta of 1.0 to the S&P 500 index, it has the same market risk as the S&P 500 index. So if this stock portfolio generates a 10.75 percent return when the S&P 500 returns 10 percent, the beta component of total return was 10 and the alpha component was 0.75. Investors can capture beta passively as it requires minimal skill. Beta is viewed as a commodity and should not command a pricing premium.
Hedge funds are at the opposite end of the pricing spectrum from beta-only index funds. Hedge funds have significantly higher fees than traditional active long-only money managers. Are the higher management fees justified? Consider a framework for comparing two managers: Manager A, a traditional long-only large-cap mutual fund with a 0.75 percent management fee, and Manager B, a long-short equity hedge fund with a traditional 2 percent management fee, plus a 20 percent fee on profits.
In this example, assume the S&P 500 Index returns 8 percent. Manager A returns 9.0 percent before and 8.25 percent after fees. Manager A has a 1.0 beta, which translates into an 8 percent alpha hurdle and +0.25 percent of net alpha. Manager B returns 7.3 percent before and 4.24 percent after fees. Manager B has a lower 0.40 beta, which lowers the alpha hurdle to 3.2 percent, and generates +1.04 percent of net alpha.
So which manager is more expensive? Manager A has the lower absolute fee (0.75 versus 3.06). However, Manager A has a higher fee if measured in terms of fee per unit of alpha. Manager A’s fee is 3 times its net alpha, while Manager B’s fee is 2.94 times its net alpha. Only 3 percent of Manager A’s total return is alpha (or 0.25/8.25 = 3 percent), while 24.5 percent of Manager B’s total return is alpha (or 1.04/4.24 = 24.5 percent). As we mentioned earlier, the beta component of total return is a commodity that can be generated passively and inexpensively. Alpha is the only component of return that warrants a pricing premium. So which manager is actually more expensive? The answer is in the eye of the beholder.
The vast majority of the total return generated by endowment and foundation portfolios comes from the exposure to the risk premiums of asset classes. These risk premiums, or betas, are a valuable and essential component of total return, but they are also fungible commodities that can be inexpensively replicated with passive management. While gaining exposure to betas may not require skill, effectively mixing those betas within a diversified portfolio does. Adding an asset class like commodity futures to a portfolio can improve a portfolio’s risk-adjusted performance, but asset classes are sources of betas and not sources of alpha.
Time and expense are scarce resources, and they should be deployed efficiently. The best place to deploy these scarce resources is to develop an optimal asset allocation strategy and to find alpha-generating vehicles; beta-generating investment vehicles do not demand a pricing premium or significant time allocation.
This alpha versus beta concept can be the most confusing when it comes to hedge funds because the investor may have a hard time understanding how a hedge fund generates its return. Given the opaque nature of hedge funds, this is a challenge for even the most sophisticated hedge fund allocators. For example, perhaps a hedge fund bets on commodity price increases by loading up on commodities. The fund profits during a period when stock prices fell. When that hedge fund presents its return stream, compared to the S&P 500 index, it might show a significantly positive alpha figure. Is this outperformance really alpha, or is it simply high beta relative to the commodity index (beta “dressed up as alpha”)? Without understanding the context, historical returns must be taken with a grain of salt.
If we look at the previous example, and don’t know if Manager B’s outperformance is “alpha” or “beta dressed up as alpha,” we have a hard time understanding whether the fee per unit of outperformance is a meaningful measure. Manager A is a large-cap mutual fund, and we have access to all its underlying holdings so we know how it generated its alpha (either through sector and/or security selection). The problem with the opacity of hedge funds is that one often doesn’t have sufficient information to make an alpha-versus-beta judgment. Investors in hedge funds require far more context about the managers’ strategies, styles, and alpha theses to make objective assessments of manager skill.
While a skilled hedge fund manager may generate alpha, a significant portion of return usually still comes from beta. (If hedge funds were alpha-only vehicles, then the average multi-strategy fund of hedge funds would not have lost more than 20 percent in 2008.) Quantifying that beta at the top-down hedge fund industry level is fairly easy. However, it’s challenging to quantify it at the individual manager level. Some managers are very skilled at dressing up beta to look like alpha.
Hedge Fund Indices and Benchmarks
A main purpose for any index is to serve as a useful benchmark, enabling investors to objectively evaluate manager performance. It is helpful to understand the minimum requirements for an index to be “useful benchmark:”
- The index must be representative of the mandate.
- The index holdings and weights within the benchmark must be identifiable and unambiguous.
- An investor should be able to replicate the index benchmark passively.
- The index benchmark’s performance must be measurable on a regular basis.
- The index constituents’ classification (i.e., strategy) in the benchmark must be formulated from public information and be consistent with market opinions.
- The index benchmark must be constructed before the measurement period begins.
Hedge fund indices seek to represent the performance of hedge fund peer groups. There are two types of hedge fund index categories and both struggle to meet the useful benchmark test. The first type is an investable index, which only includes funds that are accepting new capital and excludes funds that are closed. In addition to serving as hedge fund performance benchmarks, investable hedge fund indices are able to be passively replicated. Therefore, they meet at least one of the useful benchmark requirements. However, by excluding managers that are closed to new investment, investible indices do not fully represent the hedge fund peer group. The second type of hedge fund index is a non-investable index. Non-investable indices also fail to meet the definition of a useful benchmark. They include hedge funds that are closed to new capital and therefore cannot be passively replicated. While non-investible indices are perhaps more representative of hedge fund peer groups, they suffer from other sorts of biases.
Index providers screen the universe on broad metrics such as assets under management and track record length in order to establish minimum requirements. Once the index providers have applied the initial screens, they classify each fund based on stated investment style (i.e., equity long-short, global macro). Each index provider then applies its own definitions for style screens. Because index providers have differing definitions and methodologies for classifying strategies, the same fund may be placed into different categories. For example, a fund may be classified as “event-driven” by one provider and “merger arbitrage” by another. Further complicating matters, some index providers use equal weights while others use asset-based weightings in their index-construction methodologies. The index providers are also inconsistent on the timing of assumed rebalancing. Some use monthly and others use quarterly or other time intervals.
Due to the private, unregistered nature of hedge funds, databases and indices have several other imperfections. Calculating index returns based on the performance of funds still operating at the end of a reporting period leads to survivorship bias. This bias may positively skew index performance because funds no longer operating are often liquidated as a result of poor performance. Established indices typically have less survivorship bias once back-filled data are no longer being used. Once a fund reports to an index, historical returns remain in the index even if they fail.
Liquidation bias occurs when funds in the process of liquidating stop reporting before being fully liquidated; the index loses several months of performance as the hedge fund winds down operation. This bias tends to skew index performance upward as a poorly performing fund is removed from the index before it is done inflicting damage on investors. Selection bias occurs because selection criteria differ by index provider and construction methods vary, leading to discrepancy among returns for competing indices that track the same strategy. Self-reporting bias occurs because there is no official hedge fund database and participation is voluntary. Managers with poor track records often do not report performance, or only begin reporting once performance has improved. Larger, more successful funds may stop reporting results as capacity is reached. Funds that have performed well may have less incentive to report because they no longer need to attract new investors. Backfilling bias occurs when there is a lag between a fund’s inception and the date it begins reporting results to a database. This bias can lead to funds entering a database for the first time only after they have established a strong historical performance track record. Presumably, the poorly performing funds may never start reporting, and simply disappear as if they never existed.
Two of the more widely recognized index providers are Hedge Fund Research, Inc. (HFR) and Dow Jones. HFR was established in 1992 and specializes in hedge fund indices, database management, and analytics. HFR produces more than 100 indices of hedge fund performance ranging from the industry aggregate level down to specific, niche sub-strategies and strategies with regional focus. With performance history dating back to 1990, the HFRI Fund Weighted Composite Index is a widely used benchmark. The HFR suite of products leverages the HFR database to provide detailed, current, comprehensive, and relevant aggregate reference points for all facets of the hedge fund industry. The Dow Jones Credit Suisse Hedge Fund Indexes are a family of hedge fund indexes that include broad market and investable indexes. The indices are constructed from a database of more than 5,000 hedge funds. The database consists of 17 indexes, including a range of geographical and strategy-specific hedge fund indexes.
Fund of Hedge Funds versus Direct Investment
Once an endowment or foundation investor has made the decision to invest in hedge funds, there are a number of ways to access them. Key criteria are the investor’s size and manager evaluation acumen. One option is to invest directly and build a diversified portfolio of hedge funds. Direct investment can make sense when the endowment or foundation allocates greater than $25 million to hedge funds and has the ability to effectively evaluate and monitor hedge fund managers. It can be challenging to build a diversified portfolio of direct hedge funds with less than $10 million regardless of the endowment or foundation’s manager evaluation and due diligence capabilities. For smaller hedge fund investors, it is preferable to invest through a fund of funds (HFOF) vehicle, where an outside manager selects and diversifies among multiple hedge fund managers and strategies.
For endowments and foundations allocating between $10 and $25 million to hedge funds, a hybrid “core-satellite” model may be appropriate. This core-satellite approach has a core investment in a HFOF, but also satellite investments in direct hedge funds. This enables the core to be diversified among multiple managers and strategies, while allowing concentration in higher-conviction strategies and managers.
Even if the endowment or foundation portfolio has sufficient size, the decision to invest directly or through a fund of hedge funds is not clear cut. If an investor elects to invest directly, he only pays one layer of fees. If an investor elects to allocate to a HFOF, he must also pay a second layer of fees.
Hedge Fund Investment Due Diligence
Hedge fund investors must either have a comprehensive due diligence program to evaluate candidates, or they should forgo investing in the space. The process starts with evaluating the qualifications and track record of the manager. An investor should review the educational and professional history of the portfolio managers and their investment management history. A manager with a background that is incompatible with the current strategy should be eliminated. Also review the education and work experience of all other key analysts and risk-management personnel. Crucial parts of the personnel review process are reference and background checks. Also review the fund’s ownership structure to ensure that interests are properly aligned. Finally, the investor should review how much of the manager’s own capital is invested in the fund; one wants managers who “eat their own cooking”.
The next step of the due diligence process is to understand the strategy of the fund. Investors must understand what instruments the fund trades and how its strategy is designed to generate alpha. As a part of the strategy review, the investor should seek to understand the types of market environments that will favor or disfavor the strategy.
Once the investor is comfortable with the strategy, one needs to understand the research process, including how investment ideas are generated. The fund’s analysts should walk the investor through the investment process from idea generation to implementation in the portfolio.
The final investment due diligence step is to understand portfolio construction including concentration, leverage, liquidity constraints, factor exposures, and other constraints such as maximum sector and position exposures. While it is helpful to have the manager describe the portfolio construction process, due diligence requires a thorough review of historical portfolio construction at various points in time (usually monthly). Historical portfolio construction that doesn’t match the portfolio construction story is a major red flag.
Financial leverage inherently increases risk. By definition, leverage amplifies gains, but it also magnifies losses. The appropriate level of leverage varies by hedge fund strategy. Explicit leverage requires borrowing, but hedge funds can also implicitly leverage assets by buying or selling futures, selling options, entering into swaps, or trading other derivatives. The investor must be comfortable with the level of leverage and understand whether it is appropriate given the strategy.
Because hedge funds often employ leverage, trade derivatives, and invest in less-liquid areas of the market, they can be prone to fat left tail events—unlikely but disastrous situations. Certain strategies exhibit return profiles similar to poorly underwritten flood insurance. They collect a steady stream of “insurance premiums,” until the flood hits and they collapse. An example of this type of asymmetric risk-reward profile is selling out-of-the-money options. Most options expire worthless. As long as the options finish out of the money, they expire unexercised and the seller pockets the premium received. Low month-to-month volatility gives the false impression of low risk . . . until the blow up. Similarly, the non-normality of hedge fund return distributions and unstable correlation coefficients make a single hedge fund or hedge fund portfolios hard to model. The best one can do is to thoroughly understand the strategy and risk-management processes before deciding to invest.
Most successful hedge funds have a robust risk-management process. The ideal is for the fund to have an independent risk-management group that reviews the risks and stress tests the portfolio under a variety of scenarios and market conditions. The risk-management team should provide copies of completed risk reports and be able to demonstrate their process. If a hedge fund exhibits a defect or hole in the risk-management process, eliminate it from consideration.
While a strong performance history is a good starting point, a full quantitative review must be done to ensure an investor fully understands the context of a manager’s return stream. Blindly chasing hot performance is a classic rookie mistake. Return attribution is important to understand a manager’s return profile. The most basic attribution is long/short attribution, which shows how a manager has performed on both the long and short portfolio each measurement period. The long/short attribution is vital to see if a manager has been successful on the short side, a requirement for any successful hedge fund manager. Obtain and study return attribution by security type, market capitalization, geography, and sector to determine other sources of return.
There are many steps in the process to determine if a hedge fund manager is worthy of consideration. The analysts performing the work should document all investment due diligence steps. The endowment or foundation’s investment committee should thoroughly review these analyst investment due diligence reports before including a fund in the portfolio.
Hedge Fund Operational Due Diligence
Hedge funds lack holdings transparency. Rightfully, many endowment or foundation investors aren’t comfortable allocating money to vehicles for which they don’t control custody and can’t look at positions. While many hedge funds have improved transparency, they still lag their registered competitors. Investors other than multi-billion dollar institutions often cannot access key individuals at the hedge fund. This situation exacerbates concerns. The vast majority of hedge funds don’t provide position-level transparency.
However, operational failure is also a major risk with hedge funds. Just because a hedge fund manager may be a talented investor does not mean he is necessarily adept or capable of running a business enterprise. Many impatient or preoccupied hedge fund managers lack the expertise and commitment to run a business with proper systems and controls. Outright fraud is also a serious risk, given the opaque and loosely regulated nature of the hedge fund industry.
On December 11, 2008, Bernard L. Madoff was arrested and later pled guilty to 11 felonies for running the largest Ponzi scheme in history. Estimates of the fraud have been as high as $65 billion! Madoff asserts his Ponzi scheme began in the early 1990s, but federal investigators suspect the fraud began much earlier, perhaps in the 1970s. As the Madoff disaster demonstrates, longevity and reputation are no substitute for the requisite independent operational due diligence.
As with all successful frauds, Madoff seemed reputable. He was well known in the industry and had even served as the head of Nasdaq. He was well connected, with a reputation for brilliance. He was also affable. However, even a modest operational due diligence effort should have raised numerous red flags. All of the following pieces of information could be found in the marketing materials of at least one of Madoff’s feeder fund:
- Madoff’s administration, brokerage, and custody were done internally.
- Madoff’s firm charged no investment management (or incentive) fee, so it presumably only made money on brokerage commissions charged for trading client accounts.
- Lastly, the auditor was a small and unknown accounting firm.
Without digging any deeper, this short list of operational red flags was more than enough to warrant elimination, but investors relied on word of mouth references. While spectacular failures and frauds like the Madoff debacle make the front page, most hedge fund failures are not spectacular. They result from simple operational failures. Hedge fund managers that are very good at executing their investment strategy may not have the time or expertise to establish and run a well-controlled business. Investors need to perform strong operational due diligence that focuses on the non-investment aspects and the associated risks of running a hedge fund.
An investor must be comfortable with the controls around the process of trading, reconciling, and valuing holdings. Operational due diligence should examine controls across the entire trading process; from the time the portfolio manager initiates the trade with the trading desk, through the settlement and reconciliation process, and ultimately through valuation and the striking of a net asset value.
Outside service providers perform many of the key operational processes. Services providers for hedge funds include the following:
- Prime Brokers provide leverage to hedge funds, execute and clear trades, and lend securities (for shorting).
- Administrators provide critical middle and back office services, as well as key client-servicing functions.
- Auditors examine holdings and provide an opinion as to whether the fund’s financial statements meet Generally Accepted Accounting Principles (GAAP).
Due to the importance of these functions, hedge fund investors must determine if the service provider is reputable and has the resources to service the hedge fund’s strategy. The investor must then learn the role each plays and understand the reliability and independence of their work. This requires the hedge fund investor to interact with all service providers.
In addition, operational due diligence should also include the other risk-mitigation activities performed by non-investment personnel. As the Securities and Exchange Commission polices insider trading, it has become paramount for hedge fund investors to vet compliance functions. The compliance function must be robust enough to ensure that firm personnel adhere to all regulatory provisions. Also, interview information technology personnel to review the firm’s disaster recovery plan. Has it been successfully tested? Also evaluate the operations staff who manages counterparty risk. Determine what plans are in place if a counterparty’s financial strength begins to deteriorate. Perform operational due diligence before an investment is made and continue it throughout the tenure of the investment. Eliminate or terminate any hedge fund with material gaps.
Hedge Funds in the Post-2008 World
While market factors since 2008 may have pressured some hedge funds to adapt to new standards of transparency, some top-tier funds have not succumbed to pressure. Still, much has changed. Regulation is the new norm for hedge funds. All funds with greater than $150 million were required to register with the SEC by July 21, 2011, creating additional regulatory burden. These additional burdens may be too much for smaller and emerging hedge fund managers.
Tighter regulation and investor demand will hopefully drive more transparency, including position-level transparency. For HFOF investors, this means a greater look-through to underlying managers and exposures. Many hedge funds that refuse to provide such transparency are losing out in the race for assets with institutional investors.
Since 2008, most hedge funds have increased operations staff to provide more timely response to client demands. Hedge funds also provide greater investment process clarity and more access to senior-level staff. More hedge funds have begun to use third-party risk-aggregation platforms to provide clients with useful information. Hedge funds have also increasingly turned to third-party administrators to provide independent monitoring and reconciliation of hedge fund books with prime brokers and custodians.
Gates (exit restrictions) thrown up by hedge funds during the credit crisis have brought liquidity terms to the forefront. Post-2008, many hedge funds provide liquidity terms that better align with the liquidity of their strategies. For example, a U.S. equity long-short manager who trades in highly liquid securities may provide greater liquidity terms. A distressed debt fund that allocates to illiquid credit instruments warrants less liquidity. Hedge fund managers have also begun to offer multiple liquidity options. The share class with the longest lock-up may entice investors with a lower fee structure. Another share class may have a “soft” lock-up that permits earlier redemptions for a fee. There has also been a move toward shorter notice periods for redemptions (i.e., from 90 to 180 days to 90 days or less).
The “Volcker Rule” embedded in the Dodd-Frank bill prohibits banks from engaging in proprietary trading. Although the rule has yet to be implemented as of early 2011, reducing the role of Wall Street trading desks within banks should ultimately reduce hedge funds’ competition for alpha.
Since 2008, there has been a shift toward lower fees. A 1.5 percent management fee level has become more common for new hedge funds versus the historical 2 percent management fee. However, a 20 percent performance fee remains the norm.
Current Market Dynamics and Future Outlook
2025 Market Environment
The first quarter of 2025 has been characterized by significant market volatility driven by the implementation of tariffs and policy uncertainty under the new U.S. administration. Total global hedge fund capital rose to a sixth consecutive record at $4.53 trillion, with an increase of $12.6 billion over the prior quarter despite challenging performance conditions. This growth demonstrates the industry’s continued resilience and the ongoing institutional demand for hedge fund strategies.
Performance in early 2025 has been mixed, with hedge funds generating positive returns of 0.7% in the first quarter, outperforming equities but underperforming bonds. The dispersion in strategy performance has been notable, with fixed income relative value leading gains while equity long/short strategies posted negative returns. This environment has highlighted the importance of strategy selection and manager skill in navigating volatile market conditions.
Emerging Trends and Opportunities
Several trends are shaping the hedge fund industry’s future trajectory. The cryptocurrency boom has created new opportunities, with the HFR Cryptocurrency Index surging 59.1% in 2024, leading all industry performance indices. Many traditional hedge funds have begun incorporating digital assets into their investment mandates, either directly or through specialized cryptocurrency strategies.
Environmental, social, and governance (ESG) considerations have become increasingly important in hedge fund investment processes, with many funds incorporating ESG factors into their fundamental analysis and risk management frameworks. This trend reflects both investor demand and the growing recognition that ESG factors can be material drivers of long-term investment performance.
The industry continues to benefit from the normalization of interest rates, which has improved the risk-adjusted return profiles of many hedge fund strategies. Market-neutral and relative value strategies, in particular, have benefited from higher short-term rates that provide attractive carry opportunities. The ongoing divergence in global monetary policies is expected to create additional opportunities for macro and currency strategies.
Conclusion
Investing in hedge funds presents unique challenges and risks, but there are compelling arguments for their inclusion in a endowment or foundation portfolio. However, endowment or foundation investors should approach hedge funds with sufficient diligence and with healthy skepticism. If your organization does not have the time or expertise to perform the required due diligence, you should either hire someone who does or avoid the strategies.
The hedge fund industry has demonstrated remarkable growth and evolution, with assets more than doubling to approach $4.5 trillion while adapting to changing market conditions, regulatory requirements, and investor preferences. The industry has matured significantly, with increased institutional adoption, enhanced operational standards, and more sophisticated investment strategies. While fee pressure and competitive dynamics continue to challenge managers, the fundamental value proposition of hedge funds—providing diversified, risk-adjusted returns through skilled active management—remains compelling for institutional investors seeking portfolio optimization.
The concentration of assets among the largest firms reflects the industry’s institutional character, while technological advancement and regulatory evolution have created both opportunities and challenges for hedge fund managers. As the industry looks toward the remainder of the decade, factors such as continued monetary policy divergence, geopolitical uncertainty, and technological innovation are likely to drive further growth and evolution in hedge fund strategies and market structure. The projection that hedge funds will surpass $5 trillion by 2028 and reach $5.5 trillion by decade’s end appears achievable given current growth trajectories and continued institutional adoption.
Notes
- Source: 2024 NACUBO-Commonfund Study of Endowments. The average allocation to marketable alternatives was 16.1 percent for the total institutions surveyed in FY2024. Marketable alternatives include hedge funds, absolute return, market neutral, long/short, 130/30, event-driven, and derivatives.
- HFR. (2024, November 7). HFRI Monthly Performance Indices - October 2024. Mondo Visione.
- Curvo. (n.d.). S&P 500: historical performance from 1992 to 2025. Retrieved from https://curvo.eu/backtest/en/market-index/sp-500
- Curvo. (n.d.). Historical performance of the Bloomberg US Aggregate Bond index. Retrieved from https://curvo.eu/backtest/en/market-index/bloomberg-us-aggregate-bond
- BlackRock. (n.d.). iShares U.S. Aggregate Bond Index Fund | BMOPX | Investor P. Retrieved from https://www.blackrock.com/us/individual/products/298425/ishares-u-s-aggregate-bond-index-fund-class-p
- UBS. (2024, November 20). HFS Bulletin November 2024.
- Nasdaq. (2024, June 30). This Stock Market Indicator Has Been 86% Accurate Since 1984, and It Signals a Big Move in the Second Half of 2024.
- With Intelligence. (n.d.). Hedge Fund Outlook 2025. Retrieved from https://www.withintelligence.com/insights/hedge-fund-outlook-2025/
- Dominicé. (2025, January 29). 2024: A Remarkable Year for Hedge Funds.
- Callan. (2025, March 26). Hedge Funds in 2025: 5 Major Trends Driving Them.
- Investopedia. (n.d.). S&P 500 Average Returns and Historical Performance. Retrieved from https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp
- PG Calc. (2025, February 14). All Boats Were Lifted: 2024 Another Strong Year for Traditional Investments. Retrieved from https://www.pgcalc.com/insight-training/pg-calc-featured-articles/all-boats-were-lifted
- Winthrop Wealth. (2024, January). OUR FAVORITE CHARTS OF 2023. Retrieved from https://winthropwealth.com/wp-content/uploads/2024/01/January-2024-Client-Question-of-the-Month.pdf
- Morgan Stanley. (n.d.). How to Think About Correlation Numbers: Long-Term Trends versus Short-Term Noise. Retrieved from https://www.morganstanley.com/im/publication/insights/investment-insights/ii_correlationnumbers_us.pdf
For more information and personalized guidance, please feel free to reach out to Vistamark Investments LLC. You can contact us at
312-895-3001, visit our website at
www.vistamarkllc.com, or send us an email to
info@vistamarkllc.com.
