One way to look at CALPERs foray into hedge funds is that ten years ago they were impatient with equity returns as the indexes floundered somewhat, so they moved into hedge funds. Now domestic equity indexes have rocketed higher and it could be argued that CALPERs has grown impatient with their choice of diversifier and so is moving out after the stock market has gone up 190%.
This post is not to defend hedge funds or opine as to whether they are suitable for anyone but the true purpose of a hedge fund, or more relevant to most readers here a fund that replicates hedge fund returns, is to offer an exposure that reduces a portfolio’s correlation to the stock market. The stock market goes up most of the time so having a large exposure to something that doesn’t look like the stock market is probably not a good idea but a small exposure can smooth out the ride over the duration of the stock market cycle.
After 66 months of a raging bull market it is logical to think that the thing you bought for a small slice of the portfolio to not look like equities will have fallen behind a broad equity index. But if a hedge fund is going to add value (and of course there is no guarantee) it will be during periods when the market is not rocketing higher.
You might read that last paragraph and think well, they didn’t work during 2008. Many of these types of things did not “work” in 2008 in part because markets stopped functioning for a time (although some strategies were indeed flawed) which distorted all sorts of asset classes, strategies and inter-market dynamics. It is extremely unlikely that markets will fail to function like that again. If that does not resonate with you then you probably should leave these sorts of products alone. I continue to believe in small exposures to diversifiers to smooth out the ride over the entire stock market cycle with no expectation that they will lead the portfolio higher in a bull market.
This article was written by AdvisorShares ETF Strategist Roger Nusbaum.