Morningstar Advisor - Spring 2007 - 22

Spotlight: Hedge Funds Lower Risk, Higher Returns. What’s Not to Like? Some funds achieve absolute returns, but others can be extremely volatile and highly correlated to equities. by Gareth Lyons The conventional wisdom on hedge funds is straightforward: Add them to a traditional stocks and bonds portfolio and you’ll reduce risk and increase returns. Hedge funds, which are more or less unregulated investment pools, have an enormous amount of flexibility in the way they operate and invest. Not only can managers place short bets on securities, but they can also invest heavily in derivatives and illiquid issues usually off limits to mutual funds. That flexibility gives the hedge manager huge opportunistic leeway, enabling funds to deliver consistent returns in varying market conditions while keeping volatility in check. Those returns can often be uncorrelated to those of other asset classes, such as stocks, bonds, or real estate, allowing the investor to gain better diversification, thereby reducing overall portfolio risk. Indeed, the last bear market for equities (early 2000 through mid-2002) highlighted the ballast that hedge funds can potentially provide. Amid what was one of the most treacherous environments for long-only managers, hedge funds produced healthy returns. Short positions delivered profits as the market was plummeting; meanwhile, volatility—the risk factor on which many hedge funds thrive—soared to record levels. Hedge-fund portfolios also profited significantly from their tilt toward securities of a small-cap and value-oriented nature. At a time when long-only mutual funds incurred double-digit losses, hedge funds were humming along. In 2002, the S&P 500 gave up 22%, while the typical hedge fund in Morningstar’s database notched a gain of 5.9%. Not surprisingly, portfolios holding hedge funds drastically outperformed those that stuck with the classic bond and stock mix. Demand for hedge-fund exposure, of course, has since soared, especially among pension and institutional investors looking to diversify risk and reach their long-term return targets. Advisors and individual investors have taken notice, too, citing the same need for diversification and absolute returns in any type of market. Improving portfolio efficiency with hedge funds is not a simple task, however. And while the graph to the right makes a convincing argument, it is also an oversimplification of how hedge funds behave. Hedge-fund strategies vary wildly in both style and objective. In turn, their risk/return characteristics tend to differ within and across categories. Although many funds do indeed achieve strong absolute returns with volatility akin to an intermediateterm bond fund, others can be more volatile and can exhibit high correlation to equities or bonds. That lack of uniformity among hedge funds not only punches holes in the conventional wisdom that hedge funds automatically improve portfolio efficiency, but it also highlights how costly a wrong move could be. K Gareth Lyons is a hedge fund analyst with Morningstar. For more on the Morningstar hedge fund categories, download our methodology paper at http://advisor.morningstar.com/uploaded/pdf/ HedgeCategory.pdf. 22 Morningstar Advisor Spring 2007

http://advisor.morningstar.com/uploaded/pdf/HedgeCategory.pdf http://advisor.morningstar.com/uploaded/pdf/HedgeCategory.pdf

Morningstar Advisor - Spring 2007

Table of Contents for the Digital Edition of Morningstar Advisor - Spring 2007