We should think about hedge funds' diversifying properties in terms of the optionality they can give investors when big buying opportunities open up across asset markets. That means three things: first, we have to consider periods that include big market moves like 2008-09; second, we have to focus on particular hedge fund strategies – not 'hedge funds' per se; and third, when we do all of this, the fact these strategies might deliver very low or even zero returns over quite a long time becomes a secondary issue.
Hedge funds as a broad group are a perfectly good (but expensive) way to allocate capital. Some of what they do you can get with a conventional balanced portfolio, so, in a standalone context, it may or may not be worth paying hedge fund fees for those risks that you can get from conventional assets. In a portfolio context – a 15 per cent allocation, say – they don't appear to move the needle much in terms of either performance or diversification.
But in that portfolio context, the optionality you can isolate from certain strategies (like volatility-trading, managed futures and global macro) certainly is worth paying for. To recognise that value, however, you need to get over your fear of holding something with low – or even zero – expected returns
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