Hedge Funds a Good Diversifier

August 13, 2013 (PLANSPONSOR.com) - Even in periods when hedge funds underperform the broad market they still provide measurable value to a portfolio, a white paper contends.

The report from the Commonfund Hedge Fund Strategies Group says hedge funds continue to present a compelling value proposition to institutional investors as volatility dampeners, absolute return vehicles in certain cases, and as less-correlated sources of return. “As an investment class they have historically demonstrated the ability to generate superior, risk-adjusted returns to the broad market,” Commonfund wrote.

The report says hedge funds’ value as diversifiers is often understated. The growth of the industry has led to an increased number of correlated managers, but it has also led to an increased number of uncorrelated managers. According to Commonfund, the single largest area of growth over time has been in the group of managers with the lowest percentage of their returns explained by those of the broad equity market. “For a thoughtful, strategic investor, this diversity provides the opportunity to attain portfolio diversification independent of market direction,” the report says.

The long-term, alpha-based case for hedge funds remains strong, despite recent declines in alpha coinciding with unusually adverse market conditions for security selection generally. In addition to significant alpha, hedge funds offer a diverse array of systematic or market exposures, Commonfund contends.

“Hedge funds are not a monolithic entity, nor should they be considered a single and uniform investment class. They are highly diverse both among and within strategies,” the report states.

Commonfund noted that in the not too distant past, hedge funds were often considered mysterious, exotic, and elusive investment vehicles that revealed little about their methods of generating return. As the industry has matured and standards of transparency have evolved, that perception seems to have faded; however, other broad tags of disapproval—such as hedge funds are expensive, glorified indexers—have more recently taken their place.

The paper said while these extremes reflect some degree of hyperbole, they also reflect legitimate concerns and important considerations for hedge fund investors: avoid investments that are inaccessible and not able to be understood, and avoid constructing a hedge fund allocation that is redundant and inefficient in a portfolio.

The white paper is here.