When we think about portfolios, most of us think about a diversified approach to investing. And while that may be true, there are different ways to optimize portfolios and different theories about which way is best. 

One approach to portfolio management is called Modern Portfolio Theory, or MPT. MPT was introduced by Harry S. Markowitz in 1952. The basic theory is was that an efficient portfolio was one that delivered the investor’s required rate of return with as little risk as possible. Risk was defined within MPT as both market risk and company specific risk.

What drives the returns on an MPT portfolio? Essentially, the goal is to buy stocks that will outperform the market. Within that approach, there will be stocks that will go up and stocks that will go down. If more go up than go down, you make money. Or, if the rising stocks go up by a larger percentage – because they have a higher beta - than the declining stocks, you will make money. 

A second approach, called the Capital Asset Pricing Model or CAPM, is credited to Wm. 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, because you would have 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 next question is where do hedge funds fit into this? The answer is they don’t! It is a totally separate approach. If we think of MPT as market-risk-plus-stock-specific risk, and CAPM as market-risk-only approach, what’s left? Well, the stock-specific-risk-only approach! This is generally the approach hedge funds follow.

Most believe that Hedge fund returns are not driven by market ups and downs. Because, in theory, a hedge fund seeks to generate returns in all market environments, independent of what the market is doing. Not surprisingly, by the middle of 2002, more than two years into a bear market, investors were buying into these alternative investment strategies. To the point where hedge funds were one of the fastest growing mutual fund product offerings. 

According to an article at Magnum Funds (www.magnum.com), “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.” 

Hedge fund strategies vary enormously - many hedge against downturns in the markets - especially important today with so much day to day noise in the markets. Although, some might argue that hedge funds are the cause of much of that noise. “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 – i.e. reduces risk – seems at odds with the more traditional view of an industry where some of the worst financial meltdowns took place.

Fact is, most of the hedge fund disasters were not directly related to the strategy. Most were caused by inappropriate use of leverage. Even the best investment strategy when subjected to excessive leverage, can blow up with an unforeseen move in the underlying markets. 

In a broader sense, hedge funds have made their mark by delivering performance numbers that appear to fly in the face of conventional wisdom. Hedge fund managers like Andy Soros and Julian Robertson produced long term returns that even traditional well known managers like Sir John Templeton and Warren Buffet would envy. No random walk down Wall street for these boys. Somehow they discovered, or invented, the holy grail by finding a way to produce better long term risk adjusted returns than should be possible in an efficient market. 

Not surprisingly then, hedge funds are sold on the basis of their returns. Rather than breaking down a particular hedge fund strategy, advisors talk about the prowess of the fund manager. Rather than discussing the diversification benefits of a particular hedge fund strategy, the industry has been focusing on hedge fund indexes that if taken literally demonstrate how much added octane a hedge fund can bring to your portfolio’s bottom line. 

The problem for me, is that Hedge fund indexes often benefit from survivorship bias. Hedge funds that blow up, get removed from the index. The fund’s that do very well pump up the performance numbers, but tell us very little about the manager’s ability. Remember, the manager is why we are buying the fund in the first place. 

A better way to look at a hedge fund is to examine the individual hedge fund strategies, in terms of what they are attempting to accomplish. Judging a manager’s value then, ought to be based on what the manager adds in terms of relative performance when measured against what the strategy could accomplish using a passive approach.

When you strip away the performance numbers, the bonus structure that is used to entice well known managers, a hedge fund is really an investment structure in which the manager makes a hedged bet in a particular market. 

In the next couple of weeks, we will look at some of these strategies. And then examine the more traditional approach for individual investors, the fund of fund approach.