What I found interesting about that question is that within the mass media, very little has been written on the various approaches to portfolio management. And if you are to really understand the role of the hedge fund - or as some prefer the role of alternative strategies - you must first understand how professional managers manage.

The classic approach to portfolio management is called Modern Portfolio Theory, or MPT. MPT was introduced by Prof. Harry S. Markowitz in 1952. The basic idea behind MPT is to construct an efficient portfolio for each client, which essentially means achieving the investor’s required rate of return with as little risk as possible.

The distinction with MPT is that the risk we are talking about is total risk, which includes both market risk and the risk that is specific to each individual security in the portfolio.
What drives the returns on an MPT portfolio? Essentially, some of the stocks in the portfolio will go up, and some will go down, and if more go up than go down, you make money.

Capital Asset Pricing Model

A second approach, called the Capital Asset Pricing Model, or CAPM, is credited to Prof. William F. Sharpe, who first suggested it in 1964. Central to CAPM theory is that you don’t need to be exposed to total risk to achieve efficient returns. The theory is that all stock-specific risk can be diversified away until all you have is market risk exposure. Investing in a broad-based market index will give you the most diversification possible --that is, no stock-specific risk.

What drives the returns on a CAPM portfolio? The thinking here is that as the market rises, it will pull all of the stocks in the index up with it, just as a rising tide lifts all boats. If a CAPM portfolio manager believes that the market will go down, and therefore pull the portfolio down, he or she transfers money out of the market into cash or T-bills.

The Hedge Fund Approach

Where do hedge funds fit into this? They don’t. Hedge funds use totally separate approach. If we look at the MPT approach as the market-risk-plus-stock-specific risk approach, and the CAPM approach as the market-risk-only approach, then what’s left? Why, the stock-specific-risk-only approach, which is what hedge funds typically follow.

In general, hedge funds isolate and embrace stock-specific risk, and eliminate market risk, by buying individual stocks and shorting the overall market in certain proportions. Key to the success of this strategy is that the stocks that are purchased must be undervalued securities. Hedge funds, therefore, focus on the analytical ability of the manager, separate from the vagaries of the overall market.

The term “hedge fund” is general, and includes a wide variety of investment strategies. A better term might be “absolute return fund,” because the main objective of a hedge fund is always to generate positive absolute returns, not returns that are better than some benchmark. In theory, a hedge fund seeks to generate returns in all market environments, independent of what the market is doing.

According to an article published by Magnum Funds, “a hedge fund can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.”

The latter point is often lost to investors. That a hedge fund actually reduces volatility - that is, reduces risk - seems at odds with the more traditional view of an industry where some of the worst financial meltdowns took place. The collapse of Long-Term Capital Management in the late’90s being a case in point.

Really, that’s the point: Hedge funds specifically do not own the market, while benchmarks are usually based on some type of market composite. In fact, the bragging rights a hedge fund has are directly related to 1) its performance and 2) how uncorrelated its return is to the overall market or markets.