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 added diversification.
Most hedge funds primary objectives are 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.
As exemplified by the hedge fund indexes, pooling hedge funds into portfolios can significantly reduce their total risk. 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.
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