The “Compound Return” is annualized over the full 1994–2014 period and on that measure hedge funds look OK. They come in at a small deficit to stocks, but beat 60/40, a much closer beta comparison (actually 60/40 is still a bit more volatile with a higher equity beta). Looking at hedge funds versus this more relevant 60/40 portfolio shows a close race in 2008 with the edge to hedge funds. Next, the row called “Full GFC” is not just 2008 as I graphed above, and which many of the articles critical of hedge funds reference, but July of 2007 through February of 2009, which is a closer approximation to the full crisis in markets. Over this more relevant period (after all, calendar years are arbitrary), hedge funds handily beat both stocks and 60/40. The next row after that is the worst drawdown for each investment. For stocks, 60/40 and hedge funds, the worst drawdowns occurred around the same time period as the GFC. Viewed over this draconian “how bad could I possibly do with perfectly bad timing” the hedge fund indices have been considerably less dangerous than 60/40 (–20% isn’t fun, but –32% is worse! — of course some of this comes from hedge funds being lower volatility than 60/40, but that’s also a drag on their long-term compound returns). 2013 is the notable exception to much of the above since hedge funds actually did decently underperform. Because that’s the most recent period, literally last year, it tends to get nearly ubiquitously overweighted in opinion pieces. Finally I show annualized compound returns over the last 10 years, a period sometimes used to criticize hedge funds versus the first half of the sample. The critique rings true, but only very quietly, has hedge funds have only trailed 60/40 by a bit.

Why Bother to “Hedge” at All if You’re Long-Term

Of course, in building a portfolio one doesn’t have to choose between stocks, bonds and hedge funds. One can and should be building a portfolio of the best combination, not looking at individual asset classes or artificially limited combinations.

A particularly misguided question related to this, in that it fails to grasp that one is building a portfolio not choosing the best single investment, is “why bother to hedge at all if you’re long-term?” I mean, long-term investors shouldn’t eschew but embrace risk as that leads to higher returns, right? And hedging is running away from risk, no? This argument, made in some of the links cited above, misses some crucial things basic to portfolio construction.

In building an optimal portfolio, all investors should look for investments that produce long-term positive returns (note, this is not the same thing as saying they always work) that aren’t very correlated to what they already own (say, stocks). The observation that a long-term, or for that matter a short-term, investor shouldn’t want merely a “hedged” portfolio is true. They should want a portfolio that hedges away the risks they already bear (say, stock market risk) and includes other sources of return not very correlated with those risks. They should want that regardless of time horizon. (I address later the issue of paying alpha fees for beta performance.)

Now I’ll look at a portfolio that’s ex post optimal over this 1994–2014 period. Now, ex post optimal always overstates how good things could have been (it’s ex post after all). It takes small victories and sees them as certainties, as we are looking backwards. But, if we can keep that in mind, I think it’s still instructive to see what these optimal portfolios look like. In other words, what would we have done if we knew what would happen over the 1994–2014 period to these asset classes?

I’ll run a simple optimization looking at the 1994 to 2014 data. The optimization looks for the highest compound return allocating passively (not changing this allocation around intra-period) across stocks, bonds, and hedge funds, without allowing leverage, and limiting realized volatility of rolling annual returns to that of the 60/40 portfolio (using annual instead of monthly volatility again just biases it a bit against hedge funds). When you do this you get the rather radical portfolio of 31% in equities, 0% in bonds, and 69% in hedge funds (yes, I’m usually the one talking about how important more bond diversification is, that’s coming soon). The results look like this: