Investing - Hedge Funds

Today is a holiday here in Austria and the markets are closed. With this opportunity lets step back from the markets for a while. Let us ponder the issue of "Hedge Funds" as they are coming out of the shadows again.

We have a funny way of blaming Hedge Funds when markets are volatile and to totally ignore them as if they didn't exist when markets are going relatively smoothly. I saw a report on CNN today saying that a lot of the volatility over the recent period was caused because of the trading activity of Hedge Funds and then they went on to show a few statistics like one fifth of the world's currency conversions is due to Hedge Funds and a half of the world's trades on commodities is due to Hedge Funds, etc. Naturally the report was not totally one-sided so that they did not seem to take sides but after having seen the report, the viewer was left with a feeling that Hedge Funds are somehow 'bad'.

When I talk about asset allocation with clients, one of the issues I bring up is the issue of Hedge Funds because in the US (and Canada) there is an impression in people's minds that Hedge Funds are really risky and that in most cases you would have either badly managed and/or regulated funds or that the people behind them in most cases will just run-off to the Caribbean... with you cash! This is in fact partly true (one cannot deny that) but only so to a small extent. I am one of the people that believe that the world of Hedge Funds is a great place. Every portfolio that is beyond low risk should include a percentage of Alternative Investments (i.e. Hedge Funds). Hedge Funds are not magical, far from it; losses can be very high just as easily as they can be greatly profitable. The point I like about Hedge Funds is that they have the ability to return you a profit when the markets are volatile (even with no apparent direction) and when the markets are falling. Over the past 8 months or so, the returns of Hedge Funds were not that great, this is because the markets were going steadily up. With a lack of volatility Equities (in rising markets) are by far the best option as this ability to profit from both rising and falling markets comes at a cost (i.e. lower returns). This I believe will change over this quarter though as the recent volatility will spark a new round of profitability in this asset class.

In my opinion, the medium sized investor needs to have the following in his portfolio in order for it to be well diversified and properly balanced: Precious Metals, some Equities in major markets, some Equities in emerging markets, Hedge Funds and a portion of Bonds (depending on market conditions). These should ideally be spread over 3 or more currencies as well. For the larger investor, I would also add in a portion of Property investment (currently focusing on emerging markets) and also have a greater diversification in terms of currencies.

Closing thought: There are those who believe that a well balanced and well managed Hedge Fund only portfolio is actually more stable and yields better results (over time) than the traditional portfolios restricted to Equities and Bonds. It does merit some thought but for the time being, Hedge Funds need to work on their PR skills and we need to monitor and regulate them a bit more... but we are getting there!