The word “hedge” in hedge fund means boring. That is the core purpose of hedging – to remove risk and make an investment more conservative. Hedging entails shorting some asset to remove the volatility it brings. Suppose you want to invest in AI so you buy some tech company stock. If you want to remove the risk of cryptocurrency exposure in those companies, you can short a specific amount of bitcoin to even things out. Now no matter how much bitcoin goes up or down, your investments remain unaffected.
In fact, hedge funds should be thought of as a bond alternative. Low risk, low returns, and low correlation to stocks. The thing that makes them special is that they are a bond alternative that also has a low correlation to bonds. If you have two assets with similar risk/return profiles but no correlation to each other, you can combine them and lower the volatility without changing the returns. This is the “free lunch” in the old “diversification is the only free lunch in investing” maxim.1 Conservative pension funds and endowments add hedge funds to their portfolios to reduce volatility while maintaining their expected returns; aggressive pension funds do this and add a carefully tailored amount of leverage to get back to the original volatility. Even Fidelity does a mild version of this in their target date funds.2
Here are some examples of implementing this with publicly available funds. The core idea is as follows:
- Take a baseline portfolio with a volatility that makes you happy and add an additional diversifer to it.
- This will lower both returns and volatility, but volatility will be lowered the most. The risk/reward ratio has improved but your returns are now lower than you want.
- Add exactly the right amount of leverage to bring the volatility up to the level that originally made you happy. You now have the same volatility as you started with but higher returns.
We’ll use a baseline portfolio of 85% stocks and 15% bonds, which is roughly the allocation in Fidelity’s 2050 target date fund. Portfolio 1 is the simplest possible example of following the steps above: it adds an extra allotment of bonds and then a small amount of leverage. Portfolio 2 adds hedge funds and then requires more leverage to bring it back up to baseline volatility.
It is confusing at first glance why the pie chart amounts in the top row do not line up with the amounts in the bottom row. What we’re doing in these examples is using leveraged ETFs to get the correct leverage multiple, which requires pulling out a pocket calculator to keep the numbers straight. Portfolio 1 uses the leveraged ETF TYD, which is 10-year treasuries leveraged 3x. Thus $15 of TYD is the equivalent of $45 of treasuries. If you have $85 of stocks and $15 of TYD, then you have the equivalent of $130 of total assets, thus a 1.3x leverage multiple. This sounds more complicated than it is, and the point is that you can pick some amount of leveraged ETF that will give you the leverage multiple you are looking for.
These are just quick examples to show what might be possible. The ideal implementation of this would include a multi-strategy approach to the hedge fund allocation and more efficient forms of leverage. In future newsletters we’ll discuss these factors and look at analyst commentary on perennial topics such as growth versus value, small cap versus large, and international versus domestic equities.
Feel free to post comments or questions below. Thanks for reading!
- Not a direct quote, but a common paraphrase from Harry Markowitz’s 1952 “Portfolio Selection” paper. This concept is what people are referring to when they mention “Modern Portfolio Theory”, and it is simply the mathematical underpinning for the general advice of diversification. ↩︎
- I’m stretching things a bit here by claiming Fidelity’s target date funds incorporate a leveraged hedge fund strategy, but they do have a leverage multiple of 1.05x and include some hedge fund-like exposure in private real estate and commodities: https://fundresearch.fidelity.com/mutual-funds/composition/315792416 ↩︎
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[…] Previously I wrote about the idea of a hedge fund portfolio: a typical portfolio of stocks and bonds, but with an added allocation of hedge funds. Hedge funds are designed to have low correlation to both stocks and bonds, so adding them to the portfolio lowers the risk. Remember, hedge funds are boring; they don’t return as much as stocks. Adding them reduces the expected returns by a little, and reduces the expected volatility by a lot. So with a carefully added amount of leverage a hedge fund portfolio matches the risk of a typical portfolio and beats the returns. […]