Hedge funds have been proven to correlate very little to traditional
asset classes. In other words, when the stock market drops 10%, it is
not at all necessary that hedge funds will lose as much, or even decline
at all. Thus, a portfolio that includes hedge funds or any asset class
whose returns depend less on the market, will benefit greatly from the
The original purpose of hedge funds is capital preservation. Hedge fund
managers have a number of risk management tools at their disposal that
could help reduce downside risk. This enables them to deliver consistent
returns in all market conditions.
Hedge fund managers also employ investment tools that can greatly
increase returns. Unlike mutual funds, hedge funds can use short
selling, invest in derivatives, leverage their portfolios, and hold
highly concentrated positions - strategies that can amplify returns
greatly. In fact, composite hedge fund indexes have consistently equaled
or beat the aggregate market indexes (such as DJIA and Russell 2000) in
the last five years.
The fact that hedge funds can provide high returns at lower risk is not
a contradiction. In general, hedge funds offer higher risk adjusted
returns than traditional investments. Pooling hedge funds into
portfolios can significantly reduce total risk as exemplified by the
hedge fund indexes. More importantly, the addition of one or more
well-chosen hedge funds to an investment portfolio can add the same
benefits to an investor's overall financial picture.
Hedge funds have been a mystery to some and thought of as an investment
device for the "Rich and Famous." Aside from the exclusivity they have
enjoyed, hedge funds are in fact the choice of many informed investors.
What makes hedge funds different, and thus the key to their unique
ability to succeed, is their diversity. The variety of hedge fund
strategies far exceeds anything offered by a traditional mutual fund or
stock broker. The strategies tend to be more niche-like in their
approach and frequently, much less dependent upon the market for returns.
Investors also prefer to invest in Hedge Funds because the fund managers
have a direct interest in the positive performance of their funds. Hedge
fund managers are compensated largely based upon how well they perform,
and in many cases, the fund manager is also one of the key investors in
the fund. These are two very strong incentives for the fund managers and
possibly why many hedge funds will achieve their goals while other
investment vehicles may not.
However, since the strategies and manager incentives vary so widely, it
is important to take the time to evaluate hedge funds and find one that
matches your objectives with a strategy and manager you believe in.