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Why Low Return Hedge Funds Are Good

In The New Pension Strategy For Canadians there was an interesting comment about the value of funds with low returns. The author promotes “absolute return assets” as one of the 5 essential asset classes for every portfolio, and lists hedge funds and inflation-linked bonds as the two ways to get that. Now we know that hedge funds have a long record of underperfoming the market just like the mutual funds with slightly lower fees (and hedge funds with truly bad results don’t even need to report them and drag down the average). Why would anyone want that in their portfolio?

I always thought it was pointless to buy into hedge funds, but theĀ author makes a surprising but reasonable argument for buying a low-return fund. If it’s not correlated with other assets, then the advantage you get from being able to rebalance among other asset classes is more than the returns you give up. Absolute return funds in particular are supposed to always produce a positive return which would make them uncorrelated with many other markets.

In the end it’s a lot like bonds. Most people don’t have them in their portfolio for the great returns, they own bonds for the stability. With the right amount you can get a boost from buying into stock markets after they fall. Good absolute return funds might be another way to do that. We know that bonds do sometimes show a correlation with stock market so having only two asset classes might not be enough to get the full benefits of diversification.

That all sounds good, but the truth is a bit more complicated than that. Absolute returns funds do have a history of periodically producing negative returns. If they don’t live up to their promise then they aren’t much use. And there are alternatives such as the inflation-linked bonds and very short-term securities that can produce consistently positive returns. Even regular cash has to get a nominal interest rate above 0.

In the end I’m not sure that any of these absolute returns funds actually produce risk-adjusted returns that are higher than the alternatives, especially after their fees. I’ll continue avoiding that type of investments. But the book does make a good point that just having two asset classes may not give you the best diversification. The other two that it mentioned were real estate and cash. I’m now adding REITs (only a small amount because of the run-up in prices) and I’ll look at including real return bonds once they get a bit more attractive.

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