From the June 2008 issue of Wealth Manager Web • Subscribe!

The Tao of Hedge Funds

This being our first monthly column on alternative investments and their appropriate use in the high-net-worth client's portfolio, it's only fair to start with a basic definition. For our purposes, the term "alternative investments" includes--but is not limited to--hedge funds; all derivatives including the mortgage-backed securities and CDOs blamed for the current subprime crisis; commodities; private equity and venture capital.

This month we'll look at hedge funds, investment partnerships which differ from mutual funds in that their capital is pooled from only the highest-net-worth (or "accredited") investors, and as private partnerships not subject to SEC regulation, their managers are free to execute strategies that differ significantly from those used in traditional investments.

This key distinction explains the lack of correlation between hedge funds and traditional investments. Although some styles such as equity long-short (managers in this discipline buy promising stocks and sell overvalued issues short) tend to wax and wane with the direction of the markets, bond-based hedge funds and those that trade commodities typically have negative correlations with equity indices.

What about volatility? As one might expect, the return from an investment designed for rich people and institutions is likely to be far less volatile than an investment that simply targets the performance of a given asset class. Indeed, the performance of the HFRI Fund Weighted Composite, a 2000-plus member index dating to 1990, has generated a 13.9 percent annual return with 6.7 percent annualized volatility, compared to the S&P 500 index, which clocks in a 8.6 percent annualized gain and 13.8 percent volatility.

How about the efficacy of hedge funds in a portfolio? Consider an investor in a typical 60 percent equity (as measured by the S&P 500 index) and 40 percent fixed income (Lehman Aggregate Bond Index) portfolio. If 4.5 percent of the portfolio is utilized each year for living expenses, with an assumption of 3 percent inflation, what are the odds the portfolio would last 30 years?

The answer, using Monte Carlo simulation, is highly dependent on the return dynamics of the two investments. If the portfolio had been initiated at some random time, there is an 89.2 percent chance that the account would last 30 years. But if the account started at the beginning of a bear market (defined as a five-year period of below-average returns), the odds of success drop to 50.3 percent.

Now let's assume that the investor allocates 25 percent of the total account to the HFRI Weighted Fund Composite. In all periods, the odds of success for the three asset-class portfolio jump from 89.2 percent to 99.0 percent. If the account began during a bear market, however, the odds are dramatically enhanced, with the chances for success jumping from 50.3 percent to 90.3 percent.

Of course, there are some real-world considerations one should mull over before taking the plunge into hedge funds. First off, all hedge funds are not created alike. Any investment in alternatives should be well diversified, and for those advisors with little experience in the area, the best way to start is by considering hedge funds of funds--a great way to capture the smooth, steady returns possible from these investments. In the months ahead we'll delve more deeply into how alternatives work, how to research them, and when they are appropriate for your HNW client.

Ben Warwick is chief investment officer of Quantitative Equity Strategies LLC in Denver and Memphis-based Sovereign Wealth Management, Inc. He can be reached at ben@searchingforalpha.com.

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