The right attitude to hedge funds

Any new investment for inclusion in a portfolio must offer an attractive, yet different, risk and reward profile compared to other asset classes. If not, adding it will produce little value. If hedge funds are included in an investment portfolio along with equities, bonds or other investments, they must not be viewed in isolation. Attention must be paid to how they interact with those other asset classes and whether their inclusion helps to meet its overall investment objectives. In broad terms, it is assumed that investors do not consider taking on an additional unit of risk unless it is accompanied by more than one unit of compensation. Investors want efficient investments that can generate the highest excess return with the lowest level of volatility. Although hedge funds may not produce a higher return than equities and bonds at all times, they do demonstrate consistently lower volatility. If they are mixed with equities and bonds in a hypothetical portfolio, portfolio optimisation can suggest that up to 100% of the portfolio should be allocated to hedge funds. Of course, intuitively investors would not tend to invest 100% of a portfolio in one asset class. Measures such as skewness and kurtosis can help to give a fuller picture of how hedge funds behave when combined with equities and bonds and how they can be weighted in portfolios.