It is not surprising that over the past three years investors have started to include hedge funds in their investment mix.
There was an annualised return from the S&P hedge funds of funds index of 7,46% in the five and a half years to June 30, compared with a negative 1,1% from global equities and 7,25% for global bonds. Hedge funds also had less than half the volatility of equities and materially less volatility than bonds.
Hedge funds - also known as alternative investments and absolute return strategies - cannot be marketed directly to the SA public but legal investments into hedge funds can be made through endowment policies. There are direct funds of funds products such as the Standard Bank Asset Selection available through the Charter Life wrapper, but funds are important components
of multiple asset class products such as Old Mutual International's (OMI) five asset class portfolios and similar products from TriAlpha (through the Absa Life wrapper) and Liberty's Global Wealth Management series.
Harin de Silva, portfolio manager of Analytic Investors in Los Angeles, says it might be tempting to invest 100% of assets into hedge funds because they seem to provide a dream combination of higher returns and lower volatility.
But he encourages some scepticism about the performance reporting data. All performance reporting is voluntary and there are two biases in the data, known as the "instant history" and "survivor" biases.
Instant history bias means that only funds with good performance add their returns to the database. De Silva says if the poor performers also reported it would bring down the average returns by 1%-1,5%/year.
Survivor bias means that the bad performers go out of business and there is an 8%-9% attrition rate in hedge funds. This is offset to some extent by successful funds that have closed to new business, but De Silva says the net effect is that reported figures are 2%-3% higher than they would be if the statistics of the funds that do not survive were included.
Sanlam Investment Management investment strategist Alex Pestana says investors should do their homework before investing in hedge funds.
"They are not a uniform group and therefore don't represent a homogeneous asset class. Given the current volatility worldwide, conservative hedge funds, with cash benchmarks, are preferable to leveraged funds."
OMI investment marketing head Kevin Scott says there are no guarantees you will make money from hedge funds if your timing is wrong. The S&P hedge funds of funds index fell by 10,3% from its peak in July 1998 and only recovered in June 1999. And it took 33 months up to January this year for the index to recover to its March 2000 levels.
De Silva says it's naive to see hedge fund strategies such as long/short equity as wholly uncorrelated to markets. Since January 1990, when reliable data on hedge funds first became available, there has been a 0,41 correlation between long/short equity funds and the market - 41% of these funds' performance is accounted for by the direction of the market rather than their skills at picking shares.
But TriAlpha deputy MD Robbie Hilkowitz says hedge funds, and other alternatives such as commodities, give scope for three-dimensional diversification. Traditionally, diversification just meant a mix of equities and bonds.
Because asset classes are not perfectly correlated it is possible to reduce the risk of a conservative fixed interest portfolio by adding equities (as TriAlpha does in its Cautious portfolio).
Based on data since January 1994, a 20% allocation to alternatives would have increased returns from the 5%-6,4% range, by almost a percentage point to 6,9%-7,3% and reduced the annualised standard deviation by about 1%.
Scott says that by combining five asset classes over the past five years, the OMI portfolios have experienced two consecutive positive months 44% of the time - better than any of the other assets classes, apart from cash.
The portfolios have experienced two consecutive negative months only 9% of the time, compared with 23% of the time for global bonds, 18% for hedge funds and 16% for long-only equities.
Hedge funds might be perceived to be a risky investment, but in these multi-asset strategies they are more often treated as a safe haven.
