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As the markets ebb and flow, the affluent individuals that we work with gain (and lose) interest in trends and asset classes. Two years ago, everyone we spoke with wanted to talk about private equity. Last year, private credit was the topic that came up in many client meetings. And this year, it’s hedge funds that are top of mind.

We don't think that's a coincidence. Amid geopolitical uncertainty, Trump tweets, and tariffs, the macro environment is harder to read than it has been in a long time. Unsurprisingly, investors look for strategies that can do something different than go up when stocks go up (and go down when stocks go down). Which is exactly what hedge funds are supposed to do - at least, in theory.

Over the last few weeks, our team has been meeting with fund of hedge fund managers (FoHFs), both for clients as well as to update our own thinking. This piece is the result: a primer on what hedge funds actually are, how they fit into a portfolio, and how you might access them if they're relevant to your situation.

The term "hedge fund" has a reputational problem. It conjures images of secretive, aggressive traders taking enormous bets, and occasionally blowing up - while still walking away with enormous fees, regardless of the outcome. There is some historical basis for this (more on that in a moment), but it's a caricature that obscures what is actually a very broad and diverse category of investments.

The origin story is instructive. Alfred Winslow Jones launched the first hedge fund in 1949 with a genuinely elegant idea: buy undervalued stocks and short-sell positions in overvalued ones, thus isolating his stock selection skills from the overall market performance (i.e. to “hedge” against market risk - hence the name). The goal wasn't speculation, but to reduce market risk while still generating attractive returns.

That original concept has since expanded. Today, "hedge fund" is an umbrella term for a wide range of actively managed, lightly regulated investment vehicles that typically share a few common characteristics: restricted to qualified investors, significant flexibility in terms of instruments and strategies, and generally oriented toward so-called absolute returns - meaning they aim to make money regardless of what markets are doing, rather than just trying to beat a benchmark.

While there is an almost limitless number of hedge fund ‘sub-strategies’, there are a few main strategy buckets that you would typically encounter:

In practice, these strategies usually behave very differently from each other. A macro fund and a stat-arb fund both call themselves hedge funds, but they have almost nothing in common. But knowing this distinction is key - especially as you think about how to include hedge funds in your portfolio.

Unlike stocks or bonds, the return drivers of hedge funds are typically not economic development or the rate of inflation, but rather short-term interest rates. One, because many of their price discrepancies that they trade are linked to short-term rates priced into the securities and derivatives contracts. And two, because they need to post collateral for their (often levered) trades - which typically comes in the form of short-term government bonds or money-market funds, which logically earn a higher or lower return depending on the interest rate environment. If one follows the historic relationship that higher interest rates tend to hurt stocks (and equally, rising interest rates can hurt long-duration bonds), hedge funds may be just the right complement in a portfolio (and vice versa).

How about return expectations? As a rough historical reference point, funds of hedge funds have seen returns in the range of 6-7% p.a. in dollar terms over time. Or as many funds would phrase it, 4 to 5 percentage points above the risk-free rate, meaning that in today’s higher-interest rate world, they’d expect their returns to be higher, too. As a potential alternative to a fund of funds, some multi-strategy funds have done better, with roughly 8–12% depending on the period, but with important caveats we'll get to below. 

Impressively, such diversified funds have achieved their returns at a volatility level of just 3-5%, meaning very low price fluctuations comparable to government bonds (and much, much lower than stocks). However, the tables can turn quite rapidly, with the average fund-of-hedge funds seeing temporary losses of more than 20% during the 2008 financial crisis. And with that word of caution, let’s turn to the risks.

Even though some (but not all) hedge fund strategies tend to be less risky in terms of volatility, it doesn’t mean that hedge funds are necessarily a low-risk investment.

First, an important, non-market challenge: Fraud. The Madoff scandal is the most famous example - a fund running a Ponzi scheme at a scale that defied belief, for decades, with the appearance of consistent, uncorrelated returns. But given their nature of concentrated and often more ‘esoteric’ bets, hedge funds can also expose you more to ‘fraud’/legal risk in the underlying companies (while not quite fraud, Bill Ackman’s $4BN loss on Valeant comes to mind). The lesson is not that hedge funds (or their investments) can be fraudulent, but rather that due diligence matters enormously and cannot be outsourced to the fund's own marketing materials. Auditor quality, counterparty arrangements, custody setup - this stuff might be boring for some, but it's the difference between catching problems early and losing everything.

Second, tail risks to hedge fund strategies (‘blow-up risk’). The collapse of “Long-Term Capital Management” (LTCM) in 1998 is the textbook case: a fund managed by Nobel laureates and former Fed officials that nearly triggered a global financial crisis and required a Fed-orchestrated bailout to prevent it. Their systematic strategies were profiting off very small price discrepancies, for example between different issuances of US government bonds. To magnify these tiny payoffs to a jaw-dropping return level (e.g. +40% in 1996), the fund employed huge leverage of a 30x debt-to-equity ratio in 1998, plus further off-balance sheet derivatives leverage amounting to a notional value of over $1 trillion, compared to just $5 billion in equity. The figurative “collecting pennies in front of a steamroller”. They were right about the underlying relationships they were trading, but simply had too much leverage and ran out of time when Russia defaulted on its debt in 1998, drying up financial market liquidity around the globe. Eventually, the fund had to be bailed out by a collective of 16 banks, which were also the main creditors (as counterparties in the derivatives LTCM traded) to avoid greater contagion across the financial system.

Third, the ‘black-box risk’. Many of the strongest-performing hedge funds strategies are quantitative in nature, driven by algorithms and data signals that are, by design, opaque. You can evaluate the track record and the risk management framework, but you are ultimately trusting a process you can't fully see. In my personal experience, this is further enhanced by the degree of secrecy in the hedge fund industry in general: While traditional public investors are required to share some or all of their positions in the market and private investors typically share their investments as they can’t be traded against, hedge funds can be extremely opaque in both their strategies and their positions. No matter if you invest in a venture capital fund, a public equity fund, or a hedge fund, you put your trust in the manager - but at least to me that was much harder if said manager was willing to share only a fraction of their ‘edge’ and portfolio composition.

Fourth, the rise of ‘multi-strategy’ funds. The most successful ones, like Millennium, have increased fees as well as redemption periods massively over time. The best multi-strategy platforms are genuinely impressive, generating low double-digit (10-12% p.a.) net returns at volatility as little as 2-3% over the past three decades. However, this performance comes at a price: One, with many of the funds simply passing through all their expenses (including team bonuses, travel and offices) to the fund. And two, with substantial illiquidity and redemption periods of two to as long as five years. They typically don’t even trade illiquid assets - it’s just that there is so much investor demand that they can dictate their terms. If you are lucky enough to get access to one of the star firms and then decide in 18 months that you need that capital, you will have a problem.

Fifth and last, tax complexity - especially for German and DACH-based investors. Many hedge funds are domiciled offshore - think Cayman Islands or British Virgin Islands - and don't qualify as transparent funds under German investment tax law (Investmentsteuergesetz). In practice, this can mean opaque reporting, difficulty determining the correct tax treatment of distributions, and in some cases a punitive flat-rate taxation (Pauschalbesteuerung) if the fund fails to meet German transparency requirements. Cross-border structures add another layer. None of this is a reason to avoid hedge funds entirely, but it is a reason to make sure your tax advisor is involved before you commit capital. In a 6-7% p.a. return range, you can’t afford to lose more than the expected tax to avoidable withholding taxes or flat-rate taxations. (As always, feel free to consult our colleague Tamara on any tax-related portfolio matters.)

Lastly, one practical note on currency: if you're a Euro-based investor allocating to USD-denominated hedge funds (that almost all hedge funds are), consider the impact of the exchange rate. Probably the last thing you want is a 10% exchange rate volatility to dominate your 3% volatility hedge fund strategy meant to provide stability and low correlation to the rest of your portfolio. Make sure to invest in a EUR-hedged share class, or hedge your currency exposure directly.

As you surely know by now, we use the Aspirational Investor Framework as a starting point for thinking about portfolio construction with clients. It organizes capital into three buckets: Safety (protecting against catastrophic loss), Market (capturing broad market returns and deriving income), and Aspirational (taking concentrated, higher-risk bets in pursuit of above-market returns). Given their variety of types, hedge funds might sit in any of the three buckets - depending on the strategy. 

In the Safety Bucket, we’d generally not consider even a diversified FoHF given the liquidity limitations, rather focusing on cash and safe, highly liquid cash equivalents like short-term bonds. However, some investors with larger long-term safety buffers might still consider a (currency-hedged) FoHF to generate returns in excess of the risk-free rates with low(er) correlations to equities and bonds. Personally, I would play it safe, but some of our affluent clients might be more ‘risk on’ even in their liquidity reserves.

To us, FoHF and broad multi-strategy funds quite naturally sit in the Market Bucket. Such funds can be thought of as an uncorrelated complement to a core equity-bond portfolio. If they can achieve 6-7% p.a., in-line with the return that our clients typically require to achieve long-term capital preservations, hedge funds can be an entirely different return source compared to your stocks and bonds, thereby adding to diversification without diluting your return target.

If you’re looking to more ‘risk-on’ hedge funds, and/or are simply not sure yet if you want to build diversified hedge fund exposure, you can also categorize them in the Aspirational Bucket. In the first category, we’d think of more concentrated macro or long/short equity funds, which can be used to express specific views and a potential higher return profile, but also with the risks (market risk and manager selection risk) that go along with it.

As with other alternative investments, investing in hedge funds is subject to practical considerations. To invest directly in most institutional (individual) hedge funds, you need to qualify as a professional investor, requiring you to prove previous investment experience as well as significant wealth. In practice, this typically also means being able to write a check of €5M or more to a single manager. That puts direct access out of reach for most affluent investors that we work with, unless you're concentrating a meaningful portion of your portfolio in a single fund (with the obvious risks attached to such a choice).

Funds of hedge funds lower the bar - and, in our view, have a bad reputation they don't fully deserve. The criticism is usually focused on the fee structure, which has you pay the fees of the underlying funds as well as the FoHF manager's fees. The typical FoHF charges around 1% p.a. in management fees, sometimes with an additional performance-related component, on top of the underlying funds’ fees (which still tend to cluster around the industry standard of 2% p.a. management plus 20% performance fee, though this has been compressing slightly).

Without a doubt, that’s not cheap - and you should always seek to reduce the overall fee burden in your portfolio. But what you get is access to a diversified portfolio of managers, including those you couldn't access directly, either because they’re closed to new money or because you couldn’t afford the minimum ticket, along with professional due diligence and ongoing monitoring. In our view, a FoHF will be the most sensible way to get hedge fund exposure to most (qualified) investors. (We wrote about a similar argument for private equity FoFs.)

There’s also the aforementioned multi-strategy funds. They offer diversification across (sometimes 100+) strategies within a single-fund structure, with a single management team doing the capital allocation. The challenge is access: the top platforms have very long waitlists and high minimums, and the fees have been rising as demand has outpaced supply. If you can get access to a top-tier platform, the case is strong, but getting access is often the real constraint. We’ve increasingly seen private banks offer access to Millenium and comparable funds - but unsurprisingly let themselves be paid handsomely for this service. Once again, be mindful of (feeder) fees.

For both FoHFs and multi-strategy funds, redemption terms matter more than most people realize. Hedge funds are not ETFs, instead offering quarterly redemption windows with notice periods (i.e. the required ‘heads-up’ you need to give to the fund) of 65–90 days. And even then, actually getting back your money might take another month or two until the hedge fund finalized their quarterly accounts on which your redemption is based. For multi-strategy funds, this can be even longer, as outlined above (2-5 years to fully redeem). Before allocating, think carefully about whether you might need this capital in the medium term - and if so, size the position accordingly.

For most investors in our target range, we think that FoHFs are the most pragmatic starting point - but it's worth briefly naming two alternatives.

First, direct fund access via private bank platforms (like Goldman Sachs or UBS offering curated hedge fund sleeves to their clients). The minimum ticket size typically is smaller, which sounds appealing, but the selection tends to suffer from inherent biases. One, banks have commercial relationships with the funds they distribute, and the best managers rarely need that channel. Two, given the banks need significant capacity to broadly distribute these funds, their shelf will usually be composed of big manager names that can ‘absorb’ this liquidity - and often those might not be the managers’ best-performing products. Lastly, you also pay for the platform - think ‘due diligence’ fees (even though you make the pick) or custody fees.

The second alternative is hedge funds in a UCITS wrapper (i.e. the standard European format for retail funds, like ETFs). They are regulated, liquid, and tax-clean for German investors, but come with other substantial trade-offs. The UCITS wrapper comes with constraints (i.e. daily liquidity, leverage limits, concentration rules), which force managers to water down the very strategies that make hedge funds interesting in the first place. In practice, a UCITS long/short fund is a very different product from its offshore equivalent, both in terms of portfolio and risk-return characteristics. For clients who prioritize simplicity and tax transparency above all else, UCITS can make sense.

If there is one thing for you to take away, it’s that not all hedge funds are created equal - and they are not for every portfolio. If your goal is to pick just one single fund for your portfolio, 99% of the funds out there are probably not right for you. But if you instead opt for a diversified (and appropriately sized) selection of funds, we think they can do something genuinely useful, which is to provide a source of return that shouldn’t move in lockstep with the rest of your portfolio. In an environment where equity valuations are stretched and macroeconomic uncertainty is high, that's worth a serious look.

Wondering whether hedge fund exposure makes sense for your portfolio - and if so, how to access it without overpaying on fees or taking on unnecessary liquidity risk?

We work with clients to evaluate exactly these tradeoffs and help them source, access and implement hedge funds, and fund of hedge funds or multi-strategy funds in particular.

Cape May Wealth Advisors is a Berlin-based wealth management firm focused on helping affluent entrepreneurs find financial independence. If you are interested in learning more about how we can help you, reach out to us via email, and make sure to subscribe to our newsletter.