Hedge funds carry a reputation problem. Between the Bernie Madoff scandal and the collapse of Long-Term Capital Management, most investors assume “hedge fund” means reckless risk. That reputation obscures a more useful truth: hedge funds and other alternative assets aren’t one thing, they’re a broad category of strategies, and their real value for a diversified portfolio is reducing volatility, not chasing outsized returns.
What “Alternative” Actually Covers
The category spans real estate (through REITs or private funds), commodities (typically accessed via funds trading futures contracts), long/short strategies (shorting overvalued securities while buying undervalued ones), multi-strategy or absolute return funds (blending several approaches to aim for positive returns in both up and down markets), managed futures (trend-following across currencies, commodities, and equities), and private equity (direct investment in companies that aren’t publicly traded). Each has a different role and a different risk profile. Lumping them together as “risky” misses the point of using them at all.
The LTCM Story, and Why It’s Not the Whole Picture
Long-Term Capital Management is the cautionary tale everyone remembers: a fund with $4.7 billion in assets at its 1998 peak, controlling over $100 billion in positions, that had posted annualized returns of 21%, 43%, and 41% in its first three years before a wave of global financial stress nearly wiped it out, losing $4.4 billion of its capital and threatening to destabilize the broader bond market given how large its footprint was. On the other end, Michael Burry’s Scion Capital, made famous by “The Big Short,” returned nearly 490% for investors by correctly identifying the risk in mortgage-backed securities years before the 2008 crisis. Both are outliers. Most hedge funds land nowhere near either extreme, and the ones best suited for a higher-net-worth portfolio tend to be the unglamorous ones built around risk management rather than big, headline-grabbing bets.
What the Numbers Actually Show
Over the ten-year period ending August 2016, a traditional 60% stock, 40% bond portfolio returned 6.7% annualized with a Sharpe ratio of 0.66 and a maximum one-year drawdown of 27.7%. A more diversified portfolio incorporating real estate, commodities, managed futures, and market-neutral long/short strategies returned 6.4% over the same period, essentially the same return, but with a Sharpe ratio of 0.74 and a maximum drawdown of only 22.1%. That portfolio delivered roughly 95% of the return with meaningfully less volatility and a smaller worst-case loss, which is the entire argument for including alternatives: not to chase higher returns, but to get comparable returns with a smoother ride.
Don’t Chase the Big Name Manager
The mistake many investors make is falling for managers who became famous off one big trade, then piling in expecting a repeat. Managers compensated with a percentage of the upside have an incentive to keep swinging for outsized bets, which isn’t necessarily what a diversification strategy needs. The actual purpose of a hedged strategy is to hedge, reducing correlation to the broader market, not to produce the next headline-making return. As a general guardrail, keeping any single alternative strategy to no more than about 10% of total assets helps make sure you’re getting the diversification benefit without overconcentrating in a manager or approach that could underperform for reasons that have nothing to do with the broader market.
Educational only, not tax, legal, or investment advice. Check primary sources and speak with a qualified professional before making financial decisions.
