Blending hedge funds into your portfolio

11 March 2015

We know you shouldn’t put ‘all your eggs in the one basket’, but if your portfolio comprises of only traditional investment vehicles – how diversified are you? Andrew Aitken, Bennelong Funds Management’s Head of Distribution, discusses.

According to AIMA1, if you only invest in benchmark oriented, long-only funds, it’s like playing the piano using just the black keys – ignoring the alternatives and potentially limiting your performance.

An integral part of your portfolio

When considering alternative investments such as hedge funds, it’s important to view them not as a stand-alone opportunity, but rather as a valuable but complementary part of your overall investment strategy.

Hedge funds play an important role in the structuring of traditional portfolios both in terms of diversification and performance over the long term. Generally speaking, hedge funds actively seek returns by exploiting investment opportunities while protecting the principal from potential financial loss.

The inclusion of hedge funds has strong implications for the risk-return profile of the resulting blended portfolio. In essence, the risks related to traditional investments and hedge funds are inherently different. The risk drivers linked to traditional investments are directly related to the underlying financial markets, whereas hedge funds’ risks are not.

Reducing the exposure to general market movements, thereby stabilising returns and having a lower correlation with the market’s volatility, can make a valuable contribution to any portfolio.

The risk-return equation

Of course, equity hedge funds aren’t completely insulated from market movements; a significant drop in listed company share prices has a flow-on effect and is typically accompanied by a drop in market liquidity, postponement of mergers and acquisitions, a widening of credit spreads and so on. But while they do not provide a complete hedge against market volatility, equity hedge funds do have the ability to limit losses.

Beyond the lower correlation to the market, equity hedge funds are also not bound by the S&P/ASX indices. Whereas many long-only funds aim to outperform their index (looking at relative risk or ‘tracking error’ – ie. did they outperform the benchmark?), equity hedge funds look at absolute returns (focusing on total risk and avoiding losses).

More broadly, hedge funds can use complex investment structures (eg, derivatives, leveraging, short-selling), which can be used for risk management as well as seeking positive returns, empowering them to potentially deliver over and above the market.

How equity hedge funds can add value

Historically, equity hedge funds have provided returns that rival those of equities over the long term, with lower volatility. According to independent data from research firm Australian Fund Monitors (AFM), which tracks over 200 Australian-offered equity hedge and absolute return funds via their Equity Fund Index, hedge funds outperformed the S&P/ASX 200 Accumulation Index over a recent 12-year period. In fact, from January 2003 to December 2014, the AFM Equity Fund Index returned 11.66% compared with 9.70% from S&P/ASX 200 Accumulation Index.

More importantly, equity hedge funds outperformed with less risk. When the usual measure of risk, standard deviation, was calculated for the two indices, the AFM Equity Fund Index came in at 7.13% p.a., whereas the S&P/ASX 200 Total Return Index was 13.11% p.a. – significantly higher. As measured by Sharpe Ratio, investors received almost twice as much reward for each unit of risk if investing in the AFM Equity Fund Index (0.91) as opposed to the S&P/ASX 200 Accumulation Index (0.48).

Complementarity is key

Unlike equities, cash, property, etc, hedge funds aren’t an asset class… nor are they homogenous. Indeed, hedge funds are a diverse group investing in a variety of assets using different investment styles and tools.

This variance can be the source of misgiving for some, but it’s this broad investment universe that is, in fact, one of the benefits of adding hedge funds to your portfolio.

Hedge funds aren’t for everyone - and their structures, strategies and risks certainly require additional research. But they can play a crucial role in providing strong performance with significantly lower volatility and can be a rewarding addition to traditional portfolios.

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