Hedge Funds: Why Choose Hedge Funds?
  1. Hedge Funds: Introduction
  2. Hedge Funds: Structures
  3. Hedge Funds: Strategies
  4. Hedge Funds: Characteristics
  5. Hedge Funds: Performance Measurement
  6. Hedge Funds: Risks
  7. Hedge Funds: Why Choose Hedge Funds?
  8. Hedge Funds: The Due Diligence Process
  9. Hedge Funds: Funds Of Funds
  10. Hedge Funds: Conclusion

Hedge Funds: Why Choose Hedge Funds?

By Dan Barufaldi

There are a variety of reasons to include hedge funds in a portfolio of otherwise traditional investments. The most cited reason to include them in any portfolio is their ability to reduce risk and add diversification. We have mentioned before how many hedge funds claim absolute return mandates whereby returns are minimally correlated with the equity market. In such a case, hedge funds provide a great diversifier, particularly in times of increased market volatility and/or an outright bear market.

Risk Reduction
In any case, a hedge fund that provides consistent returns increases the level of portfolio stability when traditional investments are underperforming or, at most, are highly unpredictable. There are many hedge fund strategies that generate attractive returns with fixed-income-like volatility. The difference between a hedge fund and traditional fixed income, however, is that during times of low interest rates, fixed income may provide stable returns, but those are typically very low and may not even keep up with inflation.

Hedge funds, on the other hand, can use their more flexible mandates and creativity to generate bond-like returns that outpace inflation on a more consistent basis. The drawback, as previously mentioned, is that hedge funds have certain terms that limit liquidity and are highly opaque. That said, a carefully analyzed hedge fund can be a good way to reduce the risk of a portfolio, but we stress again the importance of proper due diligence. ( Learn more in Due Diligence In 10 Easy Steps.)

Return Enhancement
The other primary reason for adding hedge funds to a portfolio is the ability of some hedge funds to enhance the overall returns of a portfolio. This objective can be considered in two ways. The first way is to maintain a low-risk portfolio but to try to squeeze out some additional returns through the use of a low-volatility hedge fund, as described in the previous section. By adding a hedge fund strategy that substitutes for an otherwise anemic fixed-income return, the returns on a portfolio can be increased slightly without any increase in volatility.

The second way, which is much more exciting, is to add a hedge fund with a high-return strategy to boost overall returns. Some strategies, such as global macro, or commodity trading advisors, can generate some very high returns. These funds generally take directional positions based on their forecast of future prices on stocks, bonds, currencies, and/or commodities and can also invest using derivative instruments. But buyer beware that although these strategies are not correlated to traditional investments, they often exhibit high levels of volatility. The result, when properly allocated, can be a nice boost in returns without a proportional increase in portfolio volatility. (Learn more in Macroeconomic Analysis.)

Allocation Considerations
Adding hedge funds to a portfolio, however, should not be taken lightly. Even a low-volatility hedge fund can explode, as we saw in late 2007, when the subprime mortgage market dried up and even securities that were paying as planned were written down to pennies on the dollar, as investors bid down their prices for fear of foreclosures. (Learn more in The Fuel That Fed The Subprime Meltdown.)

The allocation to hedge funds should consider the overall risk/return objectives of the portfolio, and proper analysis should be conducted to determine how and whether a particular hedge fund fits into the asset mix. A portfolio manager should not only consider the weighting given to any particular investment, but should also evaluate the level of concentration of the overall portfolio, and the correlation of each position relative to each other. For example, in a very concentrated portfolio, it is even more important that each position is less correlated to others, and one must also make sure that positions do not have similar performance drivers.

Yet another consideration when adding hedge funds to a portfolio is the level of gross and net exposure of the overall portfolio. With traditional investments, for example, gross and net exposure will always be the same and will never exceed 100% unless the portfolio adds its own leverage to its positions. With hedge funds, however, many of them employ leverage and in many cases, their net exposure is influenced by their long and short positions.

Therefore, a larger allocation to hedge funds will directly affect the total exposures of an entire portfolio. To use a highly leveraged fund as an example, assume a 10% position in a fund that is 10-times levered. If all other portfolio positions maintain a 100% exposure, the addition of a 10-times levered hedge fund will increase the gross exposure of the entire portfolio to 190%. The implications of this change can be dramatic depending on the strategy being used by the hedge fund.

Hedge funds have a definite place in portfolios for both return enhancement and diversification. They do have some drawbacks that should be seriously considered during the portfolio construction process, but carefully selected hedge funds, or even hedge-fund-like strategies, are a great addition to any portfolio.

Hedge Funds: The Due Diligence Process

  1. Hedge Funds: Introduction
  2. Hedge Funds: Structures
  3. Hedge Funds: Strategies
  4. Hedge Funds: Characteristics
  5. Hedge Funds: Performance Measurement
  6. Hedge Funds: Risks
  7. Hedge Funds: Why Choose Hedge Funds?
  8. Hedge Funds: The Due Diligence Process
  9. Hedge Funds: Funds Of Funds
  10. Hedge Funds: Conclusion
  1. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  2. Benchmark

    A standard against which the performance of a security, mutual ...
  3. Equity Risk Premium

    The excess return that investing in the stock market provides ...
  4. Alpha

    Alpha is used in finance to represent two things: 1. a measure ...
  5. Capitalization Rate

    The rate of return on a real estate investment property based ...
  6. Equity

    Equity is the value of an asset less the value of all liabilities ...
  1. Are hedge funds regulated by FINRA?

    Alternative investment vehicles such as hedge funds offer investors a wider range of possibilities due to certain exceptions ... Read Full Answer >>
  2. What is the purpose of a hedge fund?

    A hedge fund is an official partnership of investors who pool money together to be guided by professional management firms, ... Read Full Answer >>
  3. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  4. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  5. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  6. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  2. Bullish Engulfing Pattern

    A chart pattern that forms when a small black candlestick is followed by a large white candlestick that completely eclipses ...
  3. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  4. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
Trading Center