Hedging the Market Relies on Performance, Volatility

Not many of us have a pressing need to invest in hedge funds. However, individual investors do use hedging strategies, so knowing the results of a recent study authorized by The Bank of New York Mellon through the services of Oxford Metrica may help investors fine-tune their hedging strategies.

Hedge funds are many and of various types, but they share two properties in common. First, they anticipate and attempt to compensate for investment portfolio loses or reductions in gains. Second, they vary in minimum initial investment but the lowest initial investment is $250, 000. Hedging strategies, on the other hand, that can be employed by the ordinary individual investor cover a wide range of choices that may or may not include the equity (stock) markets and can be entered into for a more reasonable cost.

Investor confidence in hedge funds was reduced after these funds became particularly volatile, which means they had significantly disparate highs and lows in investment returns over narrow intervals of time. The Mellon study found that this lack of confidence was preceded by general confusion about appropriate use of hedge funds for portfolio diversity and by unrealistic expectations about hedge fund returns, or gains. These two points, confusion and expectations, can be relevant to individual investors who wished to employ hedging instruments to add a degree of safe-guard to private portfolios.

The study pinpointed two problem areas that contribute to the confusion about the proper use of hedges in fund diversification and to unrealistic returns expectations. The returns, or gains, on hedge funds and the returns on equity portfolios can converge, that is they can approximate each other, leading to a perception of hedge funds as having low volatility and low risk value. And hedge fund classification can involve overlap of types of portfolio instruments that comprise the fund as well as give inadequate reflections of the funds' actual market performance, or the funds' gains and losses over time. Even though this analysis is particular to hedge funds, these concerns about volatility and risk and the actual success or failure of hedge strategies are applicable to individual investors.

The study discovered several things that could renew investor confidence in hedge funds. Among these suggestions, some are applicable to private investors thinking about or engaging in hedge strategies: classification, volatility and alpha generation.

Mellon found that hedge funds are better classified by cluster analysis rather than by fund manager style and strategy analysis. Cluster analysis classifies a fund in consideration of the history of returns the fund generates over accumulated specific periods of time, whereas style cum strategy analysis classifies a fund by the manager's choices of strategy, e. g., making the choice for a high volatility portfolio over a low volatility portfolio. This pertains to private investors because they, too, will choose best when they choose based on performance within their own portfolio as opposed to what is the trendy instrument to use.

The study also found that over time, volatile drifter funds--drifting from one performance cluster to another--were underachievers: they failed to attain consistent alpha returns. All individual investors want to strive for their portfolios to ultimately out perform the beta gains reflected in indexes like Standard & Poor's (S&P). A beta return is a return comparable to the performance of the best market indexes. If a fund or an individual portfolio achieves higher returns than the indexes, then the difference between the beta and the fund or portfolio return is alpha: X percent better performance than the overall market.

With a clear grasp of the particulars relating to hedge funds and, for most of us, hedge strategies, appropriate and realistic returns expectations can be established pertaining to diversification of investment portfolios.

"New Hedge Fund Classifications Would Promote Transparency and Boost Investor Confidence, According to Bank of New York Mellon Study," The Bank of New York Mellon.