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January 11, 2014

Hedge Fund – What role in your portfolio (part 1)

Hedge Funds enjoy rising popularity from large institutional investors. During the market stress of 2008, when the MSCI World Index lost 42%, the broad Credit Suisse Hedge Fund index lost “only“ 19%. With the lower volatility, it is no surprise that institutional investors have increased their exposure to Hedge Funds, which have seen assets under management rise by more than 30% since 2007. Should private investors follow the lead of institutional investors and also seek exposure to Hedge Funds?

To assess the suitability of Hedge Funds, investors have to look at return vs risk. One key metric is the Sharpe ratio. It basically tells you what return a fund manager has achieved with a given unit of risk. Given the choice, investors will always pick a fund manager that can generate a given return with a lower amount of risk. A Sharpe ratio below 1 means that a fund manager had to take a lot of risk to achieve the returns while a Sharpe ratio above 1 represents the holy grail, i.e. the fund manager generated high returns with little risk.

Sadly, the following table from Credit Suisse shows that the performance from Hedge Funds over the last 20 years has been disappointing. If you look at the last column on the right, you can see that the Sharpe ratio for the aggregate index was only 0.78. Basically any strategy where the Sharpe ratio is below 1 is not worth a lot of fees. Strangely enough, most Hedge Funds still get away with the fabled 2%/20% fee model.

Hedge Fund Performance

The table also reveals which strategies have a Sharpe ratio above 1. Only 2, special situations and multi-strategy (Event Driven). Both strategies require a lot of ground work and are typically independent of bigger macro-trends.

The table thus answers the question which role Hedge Funds should play in a portfolio of private investors. With a few exceptions, private investors are well advised not to put money into Hedge Funds. This is particularly true for structured Hedge Fund products that try to mirror broad Hedge Fund indices while charging high fees.

This is the first article in a series on Hedge Funds. Please contact us if you have any questions.

The author previously covered Hedge Funds in London and Hong Kong while working for a global investment bank.

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