We combined these alternative asset class indexes equally into an index that we call the "Diversified Asset Portfolio,"2 and we compare its performance with that of a commonly used HFOF index3 and that of the traditional 60% equity/40% bond mix in Table 2.
As you can see, the Diversified Asset Portfolio outstripped all the other combinations. It achieved an annualized 8.0% return with a modest 5.1% standard deviation, resulting in an attractive Sharpe ratio of 0.86 over the 10-plus year study horizon.4 Meanwhile, the HFRI FOF Composite Index produced only 6.4% annually and with a higher standard deviation to post a Sharpe ratio of 0.38. In other words, the Diversified Asset Portfolio posted twice the risk-adjusted return of hedge fund of funds.
When we limited the comparison to bad times for investors, so we could focus on the absolute return theme, we found that the worst calendar year for the Diversified Asset Portfolio (2001) provided a return of -1.2% versus a return for the worst year for hedge funds of funds (1998) of -5.1%.
Note, however, that either the Diversified Asset Portfolio or the HFRI FOF Composite Index gave investors higher returns and less risk than the conventional 60%/40% mix.
To be sure, a dedicated hedge fund allocation certainly has a place in many portfolios. The sizable fee drag and mediocre results of hedge funds, however, suggest that most investors will be better served by broadening their exposure to liquid asset classes before wandering down the hedge fund path.
1. "Hedge funds end 2007 in positive ground-HFR," Reuters UK, January 8, 2008, http://uk.reuters.com/article/marketsNewsUS/idUKN0851883720080108
2. The Diversified Asset Portfolio is an equally weighted portfolio (10% each) of commodities (represented by the Dow Jones AIG Commodity Index), REITs (represented by the Wilshire REIT Index), emerging market bonds (represented by the JPMorgan Emerging Markets Bond Index Global), TIPS (represented by the Lehman U.S. TIPS Index), high-yield bonds (represented by the Merrill Lynch High Yield Master II Index), long-term U.S. government bonds (represented by the Lehman Brothers Long-Term Government Index), unhedged non-U.S. bonds (represented by the JP Morgan GBI ex-US Unhedged Index), international stocks (represented by the MSCI EAFE Index), and U.S. stocks (represented by the S&P 500 Stock Index. U.S. investment-grade bonds are represented by the Lehman (LB) Aggregate Bond Index.
3. We are using the HFRI fund-of-funds benchmark because it reflects the results experienced with live money better than the HFRI single hedge fund indices, which are subject to selection, survivorship, and backfill biases. For more discussion of this issue, see Ennis and Sebastian ("A Critical Look at the Case for Hedge Funds," Journal of Portfolio Management, Summer 2003) and Fung and Hsieh ("Hedge-Fund Benchmarks: Information Content and Biases," Financial Analysts Journal, January/February 2002).
4. The time horizon covers the common period in which the selected indices reported performance data. The governing class for the start date is the Lehman U.S. TIPS Index, which started in 1997 with the launch of TIPS by the U.S. Treasury.
© Research Affiliates®, LLC 2008. The material contained in this newsletter is for information purposes only. This material is not intended as an offer or solicitation for the purchase or sale of any security or financial instrument, nor is it advice or a recommendation to enter into any securities transaction. The information contained herein should not be construed as financial or investment advice on any subject matter. Neither Robert D. Arnott nor Research Affiliates and its related entities warrants the accuracy of the information provided herein, either expressed or implied, for any particular purpose. Nothing contained in this newsletter is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this newsletter should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
ROBERT ARNOTT, Chairman and Founder of Research Affiliates, LLC.
JOHN WEST, CFA, Associate Director, Marketing & Affiliate Relations of Research Affiliates, LLC