Hedge Fund Investing: Perception and Reality

Counter to widely held perceptions, hedge funds as an investment class have exhibited considerably less volatility and smaller drawdowns than traditional long-only equity investments. A basic concept that all investors should understand about hedge funds is the key rationale for why they are not merely a legitimate investment, but even a compelling one. A major advantage of hedge funds versus traditional investments is that they encompass an extremely diverse range of strategies. Hedge funds have one important advantage over traditional stock and bond investments: They encompass a heterogeneous range of investments, which allows for a much greater degree of diversification than is achievable within the traditional investment world. This feasibility for creating well-diversified portfolios is the key reason why hedge fund portfolio return/risk levels are significantly higher than equity index or mutual fund return/risk levels. The combination of the higher return/risk ratios of hedge fund portfolios and their moderate diversification with equities implies that adding a hedge fund allocation component can usually be expected to enhance the return/risk performance of traditional portfolios. There is a wide chasm between facts and perception regarding hedge funds as an investment alternative. Hedge funds are perceived to be high-risk investments that offer high return potential. The empirical evidence, however, indicates that hedge funds are considerably less risky than traditional equity investments, while offering roughly similar return levels.