Hedge Funds Aren’t Worth The Risk Part 5 – What Hedge Funds Do Right

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Hedge funds are encumbered by high fees, limited transparency, inaccurate returns, poor liquidity, and practically no regulatory control. But they do incorporate some investments strategies that you can emulate.

Half a mistake: In an effort to reduce short-term downturns in securities, many hedge funds invest in both long and short equity positions. If the market goes up they make some money on the long positions. If the market goes down, they make some money on the short positions. When they invest in both, they are guaranteed to never be more than half wrong. You can apply this principle in situations of ambiguity. If you should make a move, the patient compromise of moving half in the new direction and holding the rest in wait-and-see position for later will keep your ride smoother and safer.

Macro-trends: Another technique hedge funds use is invest in large scale trends that can be expected to continue moving in one direction. The devaluation of the US dollar has provided challenges to the typical US stock and bond portfolio over the past few years.

Since peaking at the beginning of 2002, the US dollar index dropped from 120 to 80 by the end of 2004. Politicians carp about the Chinese Remembi exchange rate being incorrect, but it is the U.S. dollar that has changed its value. Several types of investments benefit from the devaluation of the U.S. dollar, but U.S. stocks and bonds are not among them, and the loss in buying power of portfolios invested solely in these investments has been significant.

Three of the six asset allocation categories that we use benefit from a falling dollar: foreign stocks, foreign bonds, and hard asset bonds. All three of these asset classes have significantly outperformed the S&P 500 during 2002-2004. During the first two quarters of 2005, the U.S. Dollar index has reversed the trend and is up 10.38%. Even during this period, these three asset classes have outperformed the S&P 500.

Emerging markets: Some hedge funds specialize in emerging market equities and debt. Although they are more volatile, emerging markets do better than developed foreign markets on average. Investing a small portion of your foreign stock allocation into emerging markets can boost returns and, because they do not move in sync with each other, reduce your portfolio’s overall volatility.

Hard assets: The category to gain the most from the dropping value of the dollar has been hard asset stocks. Hard asset stocks include companies such as oil, natural gas, precious metals, and real estate investment trusts. Hard asset stocks include many alternative investments used by hedge funds because they often do not move in sync with the U.S. markets, and because they protect investors from a falling dollar. They go up in value when the dollar drops in value for this reason: If a gold mining company can make a $10 an ounce profit when gold is at $300 an ounce, when gold goes to $390 (a 30% increase) their profit goes up 1,000%.

Your investment in hard asset stocks helps balance inflationary pressures that might erode the buying power of your U.S. bond investments. Hard asset stocks are an asset class that is important not to neglect.

Value: Even in the U.S. stock category there are strategies that can reduce risk and increase returns. Outside of the bull market of the 1990s, small cap and value have outperformed large cap and growth investments. Back in February I wrote about the value of emphasizing value stocks. This is a common technique for the long side of hedge fund portfolios. If you have been emphasizing small and mid cap over large cap and value over growth then your U.S. stock investments have out performed the S&P 500 each year for the past three and a half years. Reducing volatility to meet your financial goals is the focus. Outperforming the S&P 500 has just happened.

Diversification: Hedge funds often take advantage of these non-traditional investments in order to seek returns that are not correlated to the typical U.S. stock and bond portfolios. Although not all hedge funds emphasize these investments, investing a portion of your assets in these categories may help you reduce volatility and increase the probability of reaching your financial goals.

You can smooth your returns by applying several of the principles used by Hedge funds without putting up with any of their drawbacks. You can avoid the high fees, limited transparency, inaccurate return reports, lack of liquidity, and poor regulatory control. You also can avoid leveraging and hedging your investments that increase risk and cause you to miss the lion’s share of bull market returns.

Photo by Annie Spratt on Unsplash

Go to part:
  1. Hedge Funds Aren’t Worth The Risk Part 1 – What Are Hedge Funds
  2. Hedge Funds Aren’t Worth The Risk Part 2 – Poor Performance
  3. Hedge Funds Aren’t Worth The Risk Part 3 – Poor Compensation Structure
  4. Hedge Funds Aren’t Worth The Risk Part 4 – High Fees and Poor Regulatory Control
  5. Hedge Funds Aren’t Worth The Risk Part 5 – What Hedge Funds Do Right
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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.