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Introduction
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Introduction

the downturn in 2001­2002, most hedge fund performance was higher
than stock returns. During this period, although some investors have been
motivated by the higher performance, an increasing number of investors
looked for a nondirectional return.
Investing in Hedge Funds to Reduce Risk
Hedge fund investors face many risks. These risks include the risks intro-
duced by the securities and currencies held by the fund; the use of leverage,
which may concentrate risks present in the positions; the risk of financing
positions; and other risks (see Chapter 11). However, many hedge funds
are considerably less risky (by several risk measures) than the S&P 500,
and many funds are less risky than the more conservative Lehman Brothers
Aggregate Bond Index.
Investors who add assets that are less risky than assets held in the port-
folio can lower the risk of the portfolio. If the investor can pick less risky
assets that are expected to earn as high a return as the other assets in the
portfolio, the investor can lower the risk of the portfolio without lowering
expected return.
Investing in Hedge Funds to Increase Diversification
Diversification can significantly lower portfolio risk, compared to the risk
of individual assets. Many hedge funds do not track stock or bond returns
closely so they are more effective in reducing risk through diversification
than simply splitting the debt and equity investments over more securities
in a portfolio.
One of the most popular measures of risk is the standard deviation
of returns. This measure is used by academic writers, traditional in-
vestors, and hedge fund investors. The standard deviation of return is
shown in equation (1.2) and can be found in almost any introductory
statistics textbook:
(1.2)
where r
t
represents a series of returns over N time periods. Usually, the
standard deviation is annualized by multiplying the results of equation
Standard Deviation
Standard Deviation
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