WHY INVEST IN HEDGE FUNDS?
Marketing literature describes a number of reasons why investors should
put part of their portfolios into hedge funds. Generally, those reasons fall
into one of three somewhat overlapping motivations: (1) to increase re-
turn, (2) to reduce risk, and (3) to increase diversification.
Investing in Hedge Funds to Increase Return
With thousands of hedge funds in existence, it is difficult to generalize
much about the expected return. Funds can experience higher returns or
lower returns than traditional assets, including stocks and bonds. Never-
theless, some hedge fund managers seek to make very high returns and
are willing to accept substantially more risk in their portfolios to achieve
that return.
Adding high returns to a portfolio increases the return in a predictable
way. The return on a portfolio is equal to the weighted average of the indi-
vidual returns; see equation (1.1):
(1.1)
where r
i
represents the return of individual assets in the portfolio and w
i
represents the weight of each asset in the portfolio.
In the late 1980s and early 1990s, a number of global macro hedge
funds (see Chapter 2 for a description of this and other hedge fund
styles) caught the public's attention. This group of funds made levered
investments in U.S. and international stocks, bonds and foreign curren-
cies. Despite the name, they were generally not hedged, although the va-
riety of their positions may have provided some risk control in the form
of diversification.
Chapter 11 demonstrates that the typical hedge fund is not as risky as
a buy-and-hold investment in the Standard & Poor's 500 stock index. For
some investors, hedge funds serve a valuable role in increasing the expected
return on a portfolio. These investors may not be happy about accepting
additional risk but are nevertheless willing to take on more investment risk
to achieve a higher portfolio return.
Over the past decade, the stock market has enjoyed high returns and
violent losses. Bonds have also enjoyed good performance over the past
two decades. During the periods of high stock and bond returns, investors
have not needed to move into hedge funds to get excellent returns. During
Introduction
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