Many hedge fund strategies have produced good risk-adjusted returns. In other words, absolute returns generated by these strategies have been attractive and have been achieved at significantly lower risk than traditional equity investment.
The Risk/Return chart below shows the rate of return and the volatility of those returns versus some traditional asset types. A rational investor should be seeking investment strategies that show the level of returns required whilst keeping volatility low. Whilst hedge funds may not be considered appropriate for the entirety of a portfolio, as the graphs below show, they may have their place in and add diversification to most portfolios.
One way in which investment theory shows the benefits of diversification and how it can reduce the volatility of returns in a portfolio, is the efficient frontier. The efficient frontier is a curve that describes the optimal combination of a portfolio of assets that aims to achieve a given level of return, with the least amount of risk. In the graph shown, the curved red line is the efficient frontier and it shows the effects of different combinations of bonds (fixed income) and shares (equity) in terms of the annualized returns and volatility of different combinations of these asset types.
Three portfolio mixes are highlighted on the graph: 90% bonds and 10% equity; 50% bonds and 50% equity and 20% bonds and 80% equity. The brown, green and blue lines show the effects of adding hedge funds to each portfolio. The effect is a reduction in volatility and an attractive increase in returns.
