Alternative investments, broadly speaking, and hedge funds, more specifically, have performed as intended over the last 20 years, modestly increasing returns and significantly reducing risk when added to a traditional stock-bond portfolio.   Selecting the appropriate vehicle is the challenge, and that task has been made easier by the introduction of new exchange-traded strategies.

Those conclusions, which are not going to silence any ardent hedge fund critics, were offered by Scott Welch, the senior managing director of investment research and strategy at Fortigent, LLC, a Maryland-based investment research and technology provider.   Welch spoke last week at a lunch sponsored by the Boston Security Analysts Society.

Fortigent serves financial advisors who typically manage assets for clients with $5 to $25 million in wealth.  It uses endowment-style model portfolios with extensive allocations to alternatives.

The rise, fall, and rise of hedge funds

Hedge fund adoption by financial advisors has gone through several distinct phases, according to Welch.  Their use in high-net worth portfolios began in earnest in the mid-1990s, mostly beginning with the use of absolute-return and long-short strategies.  The former were used to complement and diversify fixed-income allocations, and the latter performed the same task for equity allocations.

Popularity increased as a consequence of the tech bubble collapse, when those funds delivered their promised results – avoiding the significant losses suffered in the public equity markets.

That experience led advisors to allocate more proactively to hedge funds, Welch said, instead of using them merely as a substitute for portions of their equity and fixed-income allocations.  Advisors embracing alternatives as part of their investment strategy began to design their asset allocations to include specific targets for various alternative strategies, and some included merger arbitrage, global macro, and other funds in addition to absolute return and long-short equity.

The financial crisis brought a sobering end to the expansion of hedge fund adoption, as their promised results failed to materialize in the 2008 market collapse.  Welch attributed these disappointing results to excess leverage, which caused funds to outperform in the bull market but amplified losses in 2008.

In addition, he said, the primary selling point of absolute-return funds – to deliver equity-like returns with bond-like volatility – violated a “law of nature.”  Those twin promises were fundamentally incompatible and ultimately impossible, and the financial crisis revealed the fallacy.