- Consistently been uncorrelated with those of stocks (0.13) and bonds (-0.10)
- Been in excess of cash
- Underperformed a 60/40 portfolio
In other words, Hedge Fund X has had very strong risk-adjusted performance, yet has provided only average absolute returns when compared with stocks and/or bonds. As a result, an investor that reallocated from stocks and bonds to fund the allocation to Hedge Fund X wouldn't have accomplished much. While the allocation did improve risk-adjusted returns of the overall portfolio, it came at a lower overall return and (as the chart shows below) it hardly moved the needle in terms of the return path. Given the amount of incremental due diligence required to make the allocation and the high fees paid (which can now make headlines for public investors), there may be buyer's remorse for the allocation (this despite the luck that was likely involved in finding a hedge fund that was able to produce such remarkable risk-adjusted performance ex-post).
The Case for Leverage: Hedge Funds as an Alpha Overlay
Using a hedge fund as an alpha source is typically performance enhancing as long as the hedge fund outperforms the investors borrowing cost (i.e. cash rate, which is currently ~0%) net of fees. This may provide an investor the ability to reduce the risk of the underlying beta portfolio without reducing the expected return of the overall portfolio. In the example below, the stock allocation was reduced to a "less risky" 50% allocation, yet the combined portfolio was still able to outperform a 60/40 blend on both a risk-adjusted and absolute return basis due to the incremental return provided by the Hedge Fund X.