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Why should I invest in a hedge fund?

A hedge fund should hedge an investor’s portfolio. Ergo, the name. Hedge funds were originally created as pedestrian vehicles that would provide a steady grind of returns hopefully significantly above the risk-free rate of return (think: T-Bills or more recently LIBOR or Euribor). The addition of a smallish component of this to the mix of an otherwise diversified portfolio of stocks and bonds would, according to Modern Portfolio Theory, improve the overall cumulative performance by damping volatility.

An example:

An Intrepid Investor has been shepherding a predominantly equity portfolio (just stocks, no fancy stuff) for years and is quite proud of it. In fact, it has walloped just about any other investment – tracking the S&P500 Index relatively well for the past 10 years or so and absolutely blowing away many globally diversified portfolios. And while over time it seems to perform on par with the typical hedge fund based on aggregate returns of general long/short equity funds, it doesn’t hold a candle to the Acme Widget Hedge Fund.

So our Intrepid Investor decides to invest in this road runner of a hedge fund, making it 20% of the overall portfolio.

The result is (or would have been, had the investment been made back in 2004) a healthy little bump in overall returns that puts his numbers slightly ahead of the S&P500.

But our Intrepid Investor didn’t invest in 2004. He pulled the trigger after watching the markets go to hell in handbasket in 2008. Funny thing is, markets don’t maintain consistent relationships over time. Equities (stocks) came roaring back after the crash of 2008. Hedge funds, being to varying degrees uncorrelated to stock markets, didn’t necessarily show the same response.

But even in light of this discrepancy between the hedged portfolio’s performance and the blazing returns shown by the S&P 500 Index, our Intrepid Investor is doing pretty well. His portfolio is less volatile than it had been. Overall return hasn’t suffered while drops in the stock portion are mitigated by less periodic change in the hedged portion. And, of course, the big question is what will happen when the next big disruption arrives; the II’s stock portfolio lost 44.5% between December 2007 and February 2009 while Acme Widget was down only 25%. The S&P 500 on the other hand lost 51% over that period of turmoil. What will happen the next time markets swoon?

What if this investment decision was made 36 months ago?

Our Intrepid Investor is happy. Great decision! So far…

Okay, but what would happen if our Intrepid Investor should select a more stable – less cartoonish – investment vehicle? One, for instance, that just hammers out consistent gains better than riskless (or at least low risk) bonds.

We will look at that scenario in the next installment.

Or you can come to https://hedgealytix.com and run your own analyses. That is, after all, the purpose of our Intelligent Tools.