Active management can result in higher risk-adjusted returns.

Over the past few decades the financial advisory profession has been employing Modern Portfolio Theory (MPT) to devise investment portfolios for clients. Under MPT, the task of asset allocation among a variety of stock, bond and cash strategies can and should be made with an eye toward achieving higher "risk-adjusted returns" for clients with less correlation with the broad equity and debt markets. Through diversification and the timely rebalancing of investments, MPT holds, portfolios have less volatility, less sensitivity to market forces and ultimately better performance results.

The almost universal adherence to MPT among the investment advisor community reflects the soundness of its bedrock principles: noncorrelation, reduced volatility/risk and superior performance, particularly in down markets. The application of the MPT, however, may have room for improvement.

The premise of this article is that for certain investors, hedge funds offer a significant complement to MPT and should be implemented when devising investment portfolios. First and foremost, hedge funds have consistently provided noncorrelated returns, even in an increasingly correlated global marketplace. Contrary to popular perception, hedge funds have also been shown to reduce the volatility of portfolio returns. Armed with a full array of portfolio management, hedge fund managers have greater flexibility to adjust to, and take advantage of, turbulent market conditions. Finally, hedge funds generally have been shown to provide enhanced returns over time, primarily by outperforming equity markets during down periods.

Achieving Non-Correlation

It is generally accepted under MPT that diversification across a variety of equity, debt and cash strategies results in noncorrelative returns to the broader equity and debt markets. Although diversification enhances noncorrelative returns, market trends have increasingly made the task more difficult. Consider the chart below, which reflects that the correlation among various asset classes (emerging markets, small-cap stocks, international stocks, etc.) has increased over time.

Investment advisors thus must consider how to guard against unintended concentration and achieve noncorrelation in the future. One way to significantly reduce correlation is to add hedge fund exposure to portfolios. Many hedge fund strategies show histories of weak, negative or noncorrelated characteristics when compared to traditional, long-only investments. For example, in contrast to the high correlations to the S&P 500 of the various traditional, long-only asset classes reflected above, the HFR Composite Index and the HFR Fund of Funds index have relatively low correlations to the S&P 500 of 0.686 and 0.486 respectively (from 1992 to 2003).

Risk-Adjusted Returns

Maximizing a client's risk-adjusted return is perhaps the hallmark of MPT. Traditional asset allocation strategies rely on diversification among various asset classes and the timely rebalancing of investments.

The inclusion of hedge funds in a portfolio is not only consistent with MPT, but may advance its objectives more efficiently. Portfolios with hedge funds generally have less volatility, less sensitivity to market forces and typically better performance results. Indeed, it is not uncommon to see hedge funds that maintain Sharpe Ratios exceeding those of most mutual fund and separate account managers.

Higher Risk-Adjusted Returns

The chart on this page summarizes the enhanced performance history of hedge funds when measured against traditional asset classes. Although hedge fund indexes are less than perfect, hedge fund performance in the aggregate can be tracked by using the broadest hedge fund index offered by Hedge Fund Research, the HFRI Composite index.

Stating that hedge funds in the aggregate have generally performed better than traditional asset classes, however, only conveys part of the story. The characteristics of hedge fund performance tell the rest: it is typically more consistent, less volatile, less sensitive to the broader equity and debt markets, and is better in down periods in the market.

Performance Consistency

Trying to beat a benchmark (relative performance) is not the principle goal of a hedge fund manager. Most hedge funds seek to make money on an "absolute" basis, meaning despite market direction. In many cases, a well-managed hedge fund has the ability not only to outperform traditional money managers in down markets, but also to create positive returns in times of market duress. Hedge fund strategies use sophisticated fundamental and statistical methods to provide consistent and competitive absolute returns.