The allure of non-traditional assets is due to their myriad of advantages when used in conjunction with more traditional asset classes. This is particularly true for hedge funds. Two things can explain the attraction that university endowments have had to hedge funds: their low correlation to the stock market (defined as the Wilshire 5000) and their reduced volatility.
Generally, hedge funds have posted returns with a less than 30% correlation to traditional asset classes. Portfolios with non-correlated asset classes achieve an additional layer of diversification. Diversification by asset class, in addition to diversification by individual asset and manager, further reduces the volatility for groups of assets. It would be unlikely for all non-correlated asset classes to suffer a dramatic decline at once in all but the worst economic conditions. Often, these asset classes will have inverse relationships, creating an environment where some assets are performing well, while others are not. This lack of correlation, diversifying asset classes, is likely to generate more consistent returns.
Hedge funds have often been less volatile than the S&P 500 Index yet have generated similar long-term equity returns regardless of market direction. Volatility, a measure of return fluctuation, can create a “roller coaster-like” portfolio experience. Investments may ascend to stunning heights, only to fall to depressing lows within a short period of time. However, investments with a low degree of volatility are often described as being “stable” or “steadying influences” on portfolio performance. A misconception with regard to risk and volatility stipulates that investments with low volatility must sacrifice performance. This has often times not been the case. Institutional investors have found that by allocating more of their endowment to alternative investments (nearly 25%), the volatility of their total portfolios has been reduced without sacrificing return. In the past, investors sought similar results from foreign equities, however, as global markets become more closely aligned, this strategy has lost much of its appeal.
Since the bursting of the technology bubble in early 2000, university endowments, with their large hedge fund component, have managed to weather the storm better than most. For example, Yale University, one of the largest proponents of alternative investments, managed to yield a positive return of 6.1% during the market carnage of 2001. As hedge funds become an ever-increasing part of mainstream investing, the sophistication of investment portfolios will increase significantly. Hedge funds may soon be considered another asset class within a well-diversified investment portfolio.
Hedge funds are becoming ever more available to individual investors. Investors may find it fruitful, if they have not done so already, to reassess their exposure to hedge funds and decide whether their portfolios are sufficiently sophisticated. Thanks to these university endowments, excellent models exist and are readily available for study. Investment advisors can distinguish and differentiate themselves by demonstrating their own sophistication and expertise with regards to their knowledge and use of alternative investments, namely hedge funds, within their clients’ investment portfolios.