August Shows Value of Prudent Diversification

There’s been a lot of talk about banks acting more and more like hedge funds. Much like the private investment pools that remain popular with endowments and other large investors, Wall Street firms such as Goldman Sachs are relying more and more on proprietary trading to generate earnings for shareholders. Last month, however, seemed to be the antithesis of the view that large, multi-billion dollar hedge funds are acting more like traditional banks.

August was a study in contrasts. Domestic equity and high-grade fixed income weathered the storm of global volatility to close mostly higher, but the loan market fell apart. Finding a bid on high-risk corporate bonds or subprime mortgages was even more difficult. As those markets came to a virtual standstill, the largest hedge funds found themselves in an extremely difficult position. Although smaller hedge funds, which rely on less exotic financial instruments, fared much better, the biggest hedge funds shouldered significant losses.

There are several lessons to be learned from this bifurcation. As much as alternative investments can be useful in increasing the return and lowering volatility in a diversified portfolio, traditional investments can be similarly valuable in a portfolio dominated by hedge funds. It also makes sense to use not only well-established funds, but smaller, more nimble offerings as well.