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In Focus #70: June 9, 2009


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Utilizing Hedge Funds in Your Portfolio


edge funds are growing in popularity. In the past nine years, hedge funds have mushroomed in number from a few hundred to over 3,000, with assets increasing from $40 billion to $400 billion, according to the December, 1999 issue of the Dow Jones Investment Advisor.

Many investors view hedge funds as speculative investments. The fact is that hedge funds do not have a common investment style. Instead, hedge funds are a type of investment structure (usually a private investment pool formed as a limited partnership or a limited liability company) which has numerous investment styles - similar to the numerous styles that we see in mutual funds.

In fact, hedge funds basically have 11 types of strategies, according to the Dow Jones Investment Advisor. They are:
  1. Equity Hedge, in which the manager combines ownership of equities with short sales of stock or stock indexes;

  2. Market Neutral (Statistical Arbitrage), in which the manager constructs a portfolio of offsetting long and short stock positions;

  3. Convertible Arbitrage, in which the manager owns convertible bonds and hedges these positions by selling short the stock underlying each bond;

  4. Distressed Securities, in which the manager invests in companies that are reorganizing, restructuring, in bankruptcy or being sold in distress;

  5. Macro, in which the manager makes profits by identifying extreme price disparities and persistent trends in equity markets, interest rates, foreign exchange rates and commodities, and then by making leveraged bets on the price movements;

  6. Fixed Income Arbitrage, in which the manager takes offsetting long and short positions in related fixed income securities and their derivatives;

  7. Merger Arbitrage (Risk), in which the manager invests in companies being acquired or involved in a merger;

  8. Fund of Funds, in which the manager invests in other hedge funds;

  9. Short Selling, in which the manager shorts stocks;

  10. Emerging Markets, in which the manager invests in companies located in developing countries; and

  11. Event Driven, in which the manager invests in companies experiencing corporate changes such as spin-offs, mergers, acquisitions, financial restructurings and bankruptcies.
Are hedge funds worth considering as investments? To answer that question, the Dow Jones Investment Advisor looked at annualized returns, standard deviations, Sharpe Ratios and returns over the 10 worst months. Standard deviation is a statistical measurement of the dispersion (of the returns) from the average (return) over a given period of time. The Sharpe Ratio assesses risk - adjusted performance; the higher the ratio, the better the risk adjusted performance.

Based upon data for the period 1/90 through 6/99 compiled by Hedge Fund Research, LLC, some hedge funds have performed well, compared to both the S&P 500 and the Lehman Corporate Bond Index. Further, some hedge funds can boast of less downside risk in declining markets, and better risk adjusted return (the Sharpe Ratio), as the table below demonstrates:

Index Annualized Return Standard Deviation Sharpe Ratio Return in 10 Worst Months
Convertible Arbitrage 11.13 3.57 1.72 -1.59
Equity Hedge 22.78 7.95 2.24 -2.62
Market Neutral 11.00 3.12 1.92 -.63
Merger Arbitrage 12.41 4.72 1.57 -2.23
Lehman Corp. Bond Index 10.11 5.63 .91 -2.28
S&P 500 18.57 13.38 1.01 -6.22


In fact, the data also shows that a combined strategy, which is an equally weighted composite index of each of the 4 hedge fund strategies - Convertible Arbitrage, Equity Hedge, Market Neutral and Merger Arbitrage - gives the highest Sharpe Ratio (2.49), a respectable annualized return (14.39), and the second lowest standard deviation (3.77). This is a compelling reason to combine several hedging strategies in one portfolio.

It is important to note that investors do not have to choose between either the S&P 500 or one of the hedging strategies in deciding how to allocate a portfolio. That is because they are not closely correlated and, hence, should be viewed as different asset classes (like stocks and bonds are different asset classes). The correlation to the S&P 500 ranges from a very low .25 for the Market Neutral hedge fund strategy, to a still low .65 correlation for the Equity Hedge strategy.

Investors should be aware of the fact that hedge funds typically have high minimum investments -- $1 million is typical. Also, many hedge funds do not allow withdrawals on demand. For example, many hedge funds do not allow an initial investment to be withdrawn for the first 12 months and, thereafter, only quarterly upon 45 to 60 days written notice.

But given the performance, in absolute and in risk adjusted terms, one can see that there are good reasons why hedge funds have gained so much popularity.



Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.

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