Lesson 8 of 8 · 13 min
Risk, return and diversification in a portfolio
Over long periods hedge funds have delivered equity-like gross returns with bond-like volatility and only moderate equity correlation, so adding them to a stock-bond portfolio has usually lowered risk and raised the Sharpe ratio, but that benefit varies over time and by strategy.
In short
- Hedge fund risk and return are hard to attribute: flexible mandates, little disclosure, illiquid holdings that are hard to mark to market, and leverage.
- Long run (1990s to mid-2010s): fund-of-funds returns above stocks and bonds before fees, with bond-like volatility, moderate correlation with stocks and almost none with bonds.
- Late 2010s: returns lagged equities while equity correlation rose, making hedge funds look less useful; some allocators use them as a bond substitute.
- Strategies differ widely; some average negative returns (short bias). Compare them by return per unit of risk.
- Market-neutral, relative value and event-driven funds tend to beat equities in downturns and when stock correlations fall, and lag when correlations are high and stocks rise together.
- Adding hedge funds to a 60/40 portfolio typically lowers standard deviation and raises the Sharpe ratio, but needs thorough manager due diligence.
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