Aside from the stigma hedge funds have received after recent industry debacles, the investment vehicles are thought of as a place to go when the stock market is misbehaving. But is this always a good idea?
In the last several years, the $400 billion hedge fund industry has become an increasingly prominent component of the investing arena, and it remains one despite its recent hurdles. Consistent returns and low equity drawdowns have attracted both institutional and high net-worth investors into the fray. But diversification is the main selling point - if hedge funds are not correlated to movements in the stock and bond markets, they should be an attractive source of returns for even the most conservative investors.
But the degree of diversification attained from hedge fund investments may be overstated. A recent study in the Journal of Alternative Investments found the movement of the S&P 500 index accounted for 79% of the return derived from U.S. equity hedge funds and 63% of the return generated from international hedge funds. These findings do not imply that hedge fund managers lack a skill component in their trading, but rather that their dependence on the larger stock indexes to generate positive performance may prevent them from realizing attractive returns during bear markets.
These results don't seem confined to equity-oriented hedge funds. based on an analysis of the major hedge fund indexes for the last five years, many hedge fund styles that use investments other than stocks are surprisingly correlated to movements in the S&P 500 stock index (See "No place to hide" right). Most likely this is due to a similar sensitivity to changes in volatility and interest rates shared by stocks, bonds, and mortgage-backed securities, which commonly are used in market neutral, arbitrage and relative value hedge strategies. Thus, it appears the use of a single-strategy hedge fund to protect against downside risk in the stock market is of questionable value.
Probably the best investment during difficult market conditions is a well-balanced hedge "fund-of-funds." Such a structure would include a plethora of strategies chosen because of its ability to profit during periods of extreme volatility in the interest rate markets and during unpredictable world events, such as political instability or war. There are a considerable number of these funds currently available. However, a study performed by James Park, chairman of the New York-based investment firm Paradigm Capital Management, showed that the average fund of funds allocates to only five managers. Although there are funds of funds that allocate across a broad array of methodologies, the fund of funds sector as a whole has apparently not embraced diversification as a risk-reducing strategy.
One way to increase the diversification in a fund of funds is by the introduction of managed futures. As shown in "No place to hide," the returns of commodity trading advisors (CTA) are not correlated to either the S&P 500 index or the returns of the major hedge fund indexes. But even though managed futures and hedge funds are both considered alternative investments, there are substantial differences between the two investments. The biggest differences are in the areas of account structuring and trading styles; other distinguishing characteristics include transparency, pricing of instruments and market liquidity.
Hedge funds are almost exclusively "fully funded"; to allocate $1 million to a hedge fund manager, that much cash must be deposited in the manager's investment vehicle. But for managed futures, there are important differences. Because CTAs only use a portion of the money allocated to them for margin, it is an increasingly common industry practice to fund a given CTA allocation only partially. For instance, a trend-following CTA might be instructed to trade a $1 million account, …