I cannot count the number of times I have read about advisors who recommend the use of hedge funds in a portfolio because they are "uncorrelated" with the overall market and "because of their ability to go short can make money in a down market".
But it seems like the story is always like this one (below). With a few exceptions of course the overwhelming evidence is that hedge funds are highly correlated to overall market trends. In fact it seems that their years of outperformance vs the market are in years when the market goes up and vice versa. And that shouldnt really be surprising the funds specialize in taking higher risks than the market through leverage and concentrated bets on the riskiest parts of the market. Thus when the market hits a speed bump their positions get hit hard.
Three clear conclusions:
1. Hedge funds are not an asset class they are a bet on an individual manager's ability to generate alpha
2. True alpha= excess returns on a risk adjusted basis is very very hard to generate on a consistent basis. Those hedgies that generate excess returns are largely not generating alpha they are taking additional risk relative to the market with leverage and concentrations in higly volatile sectors. Add in the lack of liquidity vs investments like listed etfs and the case for hedge funds diminishes future. A true evaluation must adjusted for both risk and lower liquidity.
3. Just when an investor needs diversification most....during market crises hedge funds provide little of it.
from the FT:
Hedge funds hit by May volatilityBy Sam Jones, Hedge Funds Correspondent
Published: May 17 2010 03:00 | Last updated: May 17 2010 03:00
Losses in the first week of May alone erased all gains made so far this year for some managers, according to investors who spoke to the Financial Times.
Large losses in a single week are not unusual for hedge funds, which typically aim to outperform markets and cut volatility, but those this month have come as a stark reminder to many of the continuing uncertainty over the economic recovery.