CHAPEL HILL, N.C. (MarketWatch) — So some of your clients are urging you to invest their portfolios in hedge funds? You’re not alone. Many advisers report such requests, borne of their clients’ frustrations with the mediocre returns of equity managers or concerns about an imminent bear market.
In almost all cases, however, the right thing to do is to push back. This column discusses a few of the arguments you can use when trying to do so.
Consider first whether hedge funds are the best way to reduce risk. Hedge funds are called hedge funds for a reason, and as a general rule they are less risky than the stock market. Only if you can provide clients with a superior alternative for reducing risk do you have a compelling argument for not investing in hedge funds.
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Fortunately, just such an alternative exists in a simple and cheap portfolio that invests 60% in a stock index fund and 40% in a bond index. Show your clients the accompanying chart, which compares the volatility of various groups of hedge funds with that of a simple 60:40 portfolio.
(Volatility, of course, is a standard measure of risk. The hedge fund data are from Credit Suisse Hedge Fund Indices. I recently devoted a full column to this 60:40 portfolio.)
Notice that the 60:40 portfolio is less volatile than many different types of hedge funds. To be sure, the index reflecting hedge funds of all types — the “Hedge Fund Index” in the chart — is slightly less volatile than the 60:40 portfolio. But too much should not be made of this, since the index’s volatility is almost certainly biased downward because some hedge funds own illiquid investments that aren’t marked to market each month. If they were, their reported returns would become more volatile.
What about performance? Believe it or not, the 60:40 portfolio comes out ahead of the average hedge fund. From the beginning of 1994 through this August, the Credit Suisse Hedge Fund Index produced a 7.7% annualized return. The 60:40 portfolio gained 8.1% annualized over the same period.
In other words, a simple portfolio combining two index funds has done better over the last couple of decades than the average hedge fund, while still reducing risk by roughly the same amount.
Of course, my comparison is with the average hedge fund, and some hedge funds did much better. But that doesn’t help us unless the hedge funds that come out on top in one period are able to repeat their performance in the second. Unfortunately, there is little evidence of that.
Not all academic research into hedge fund performance reaches the same conclusion. But several studies have found very limited persistence in hedge fund rankings from one period to the next — and much of what does exist is at the bottom of the rankings.
That means that there is an above-average chance that a terrible hedge fund in one period is likely to be terrible in the next period too. That’s useful information only if you’re trying to pick a losing hedge fund.
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Another indication of how difficult it is to pick a good hedge fund comes from the mediocre performance of funds that invest in hedge funds. These funds employ teams of statisticians and analysts to investigate each fund to identify those with the greatest odds of beating their benchmarks. Yet, according to research conducted by Duke University finance professor David Hsieh, just 2% of funds of hedge funds earn enough to even make back their high fees.
If funds of hedge funds with large staffs are unable to pick winning hedge funds, what makes you think you can do any better?
Yet another potential comeback from hedge fund devotees is that even though the average hedge fund doesn’t beat a simple 60:40 portfolio, hedge funds are so uncorrelated with the stock market that they deserve a place in our portfolios. This argument, too, doesn’t withstand scrutiny.
Consider the correlation coefficient, which measures the degree to which two data series are correlated with each other. It ranges from +1, in the event of perfect correlation, to -1, for perfectly inverse correlation. (Zero means there is no detectable correlation.) The correlation coefficient of the Credit Suisse Hedge Fund Index and the S&P 500 since the beginning of 1994 has been a high 0.57, meaning that, to a significant extent, the average hedge fund moves up and down along with the stock market.
And, because of the problem mentioned above in marking hedge funds to the market each month, this correlation coefficient is undoubtedly downwardly biased. In other words, the average hedge fund likely moves even more in lockstep with the market than the 0.57 correlation coefficient indicates.
The comparable correlation coefficient for intermediate-term bonds, in contrast, is -0.18. That means that, more often than not, bonds move down when stocks move up — and vice versa. That’s just what you want in a hedge, of course, leaving little wonder why bonds are such an attractive asset class for diversifying an equity portfolio.
Of course, you might have other reasons for investing in a hedge fund. It might be, for example, that a hedge fund provides the easiest way for you to become exposed to an alternative asset class. This discussion is by no means definitive.
But, at a minimum, it should shift the burden of proof back onto investors who insist that there’s something missing from their portfolios if they don’t contain hedge funds.
For more information, including descriptions of the Hulbert Sentiment Indices, go to The Hulbert Financial Digest or email [email protected]