Alternative investments, like hedge funds, can be seamlessly blended into portfolios, but the trick is to remember they are not an asset class in their own right, Andrew Aitkin writes.
According to the Alternative Investment Management Association, if you only invest in benchmark oriented, long-only funds, it’s like playing the piano using just the black keys - ignoring the alternatives and potentially limiting your performance.
However, when considering an alternative investment approach, such as hedge funds, it is important to view them not as a stand-alone opportunity, but rather as a complementary part of your overall investment strategy.
Hedge funds can play a role in the structuring of traditional portfolios both in terms of diversification and performance over the long term. Generally speaking, they actively seek returns by exploiting investment opportunities while protecting the principal from potential financial loss.
The inclusion of hedge funds has strong implications for the risk-return profile of the resulting blended portfolio. In essence, the risks related to traditional investments and hedge funds are inherently different. The risk drivers linked to traditional investments are directly related to the z underlying financial markets, whereas hedge funds’ risks are not.
The risk-return equation
Of course, equity hedge funds aren’t completely insulated from market movements; a significant drop in listed company share prices has a flow-on effect and is typically accompanied by a drop in market liquidity, postponement of mergers and acquisitions, a widening of credit spreads and so on. But while they do not provide a complete hedge against market volatility, equity hedge funds do have the ability to limit losses.
More broadly, hedge funds can use complex investment structures (e.g. derivatives, leveraging, short-selling), which can be used for risk management as well as seeking positive returns, empowering them to potentially deliver above the market.
Complementarity is key
Unlike equities or cash, hedge funds aren’t an asset class, nor are they homogenous. Indeed, hedge funds are a diverse group investing in a variety of assets using different investment styles and tools.
This variance can be the source of misgiving for some, but it’s this broad investment universe that is, in fact, one of the benefits of adding hedge funds to your portfolio.
Hedge funds aren’t for everyone - and their structures, strategies and risks certainly require additional research. But they can play a crucial role in providing strong performance with significantly lower volatility and can be a rewarding addition to traditional portfolios.
Andrew Aitken is head of distribution at Bennelong Funds Management.