Investment strategies for volatile markets

GLOBAL INVESTOR 3.07 41
Basics of
hedge funds
The 2000–2003 equity bear market contributed largely to the popularity of hedge funds, as
they generally delivered at least modest gains, while equity markets entered their worst bear market
since the oil shock of 1973. Private and institutional investors have been piling up a significant
amount of capital in hedge funds since then.
Cédric Spahr, Head of Alternative Investment Research and Portfolio Analytics, Reto Meneghetti, Alternative Investment Analyst
Estimates of assets under management in the hedge fund industry
oscillate between USD 1.5 trillion and USD 1.8 trillion, with persistently
high growth rates. Not surprisingly, we are starting to see
capacity problems, and obtaining access to the better hedge funds
has become more challenging. Despite sometimes overblown return
expectations, the risk/return profile of hedge fund portfolios
usually makes a useful contribution to portfolio diversification.
Hedge funds do not represent a panacea that delivers high returns
with low risk, but offer a useful combination of reasonable returns
with low-to-medium volatility for diversified hedge fund portfolios.
Hedge funds: In search of absolute returns
From 1994 to 2007, the Swiss Market Index delivered an annualized
average return of 10.4%, the S&P 500 9.7% and the CS Tremont
hedge fund index 9.9%. The drawdown chart (Figure 1) shows that
hedge fund investments limit downside risk in times of equity bear
markets. Some specific styles, such as equity long/short, eventdriven
or global macro, outperformed equities from 1993 to 2007,
reflecting superior manager skills. This underscores the importance
of manager selection, since many of those funds are closed
to new investors. While top managers can outperform, average
hedge fund investments can be expected to lag equity performance
somewhat over the long term, as they necessarily sacrifice
some upside potential to achieve reduced volatility. In other words,
hedge funds should sail the seas with the comfort of an ocean
liner, while equity investors should on balance reap higher returns,
but with the reduced comfort of a sailboat. Both ways of traveling
appeal to specific groups of people, and investors can determine
for themselves how forceful their investment styles should be.
Hedge fund investments can help smooth out the return pattern of
a portfolio and should usually act as a building block for all modern
asset allocation strategies. Given the decreased attractiveness of
bonds, which might suffer from a further rise in bond yields over
the medium term, the role of hedge funds in portfolio construction
is especially important at the current stage.
The hedge fund industry in a nutshell
Hedge funds have evolved from a minor asset class to a major
industry since 1990. Hedge fund assets under management have
approximately grown by an average of 22.4% per year over the last
16 years (see Figure 2). The fast growth of the industry can mainly
be attributed to hedge funds’ greater freedom to invest in different