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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 under-performing 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.

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.

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.

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.

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