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How do stocks, bonds
and hedge funds
fare as investment
vehicles as opposed
to stocks, bonds
and managed futures?
Why should I consider
adding managed futures
to my overall portfolio?
Many investors share
the common misconception
that hedge funds
offer investors
the best of both
worlds, namely expectations
of returns similar
to equities combined
with risk parameters
normally associated
with bonds.
In 2003, the Journal
of Investment Management
published an article
titled “Stocks,
Bonds and Hedge
Funds: Not a Free
Lunch!” The
author of the article,
Mr. Harry Kat of
the Cass Business
School in London,
showed that although
including hedge
funds in a traditional
investment portfolio
may significantly
improve that portfolio’s
mean variance characteristics,
it can also be expected
to lead to significantly
lower skewness.
Skewness is a statistical
term used to describe
a situation's asymmetry
in relation to a
normal distribution.
Later, in the winter
of 2003, Mr. Kat
published the article
“Taking the Sting
Out of Hedge Funds”
in which he stated,
“Although
the inclusion of
hedge funds in an
investment portfolio
can significantly
improve that portfolio’s
mean-variance characteristics,
it can also be expected
to lead to significantly
lower skewness and
higher kurtosis.”
In this article,
the author shows
how this highly
undesirable side
effect can be neutralized
by allocating a
fraction of wealth
to out-of-the-money
put options on the
relevant stock index.
Roughly speaking,
the costs of the
proposed skewness
reduction strategy
will be higher 1)
the higher the hedge
fund allocation,
2) the lower the
expected equity
risk premium, and
3) the higher the
bond allocation
relative to the
equity allocation.
In the current low
interest rate environment,
for portfolios with
a more or less equal
allocation to stocks
and bonds, the costs
of skewness reduction
are unlikely to
be much higher than
1% per annum.
For portfolios with
relatively high
bond allocations,
however, the costs
could amount to
3% or even more.
This confirms that
the benefits of
hedge funds heavily
depend on the portfolio
they are added to
and that the attractive
mean-variance properties
of (portfolios including)
hedge funds may
come at a significant
price.
Mr. Kat furthers
this research in
another report,
“Managed Futures
and Hedge Funds:
A Match Made In
Heaven,” from the
Journal of Investment
Management (2004).
He wrote,
“We find that allocating
to managed futures
allows investors
to achieve a very
substantial degree
of overall risk
reduction at, in
terms of expected
return, relatively
limited costs.
Apart from their
lower expected return,
managed futures
appear to be more
effective diversifiers
than hedge funds.
Adding managed futures
to a portfolio of
stocks and bonds
will reduce that
portfolio’s standard
deviation more and
quicker than hedge
funds will, and
without the undesirable
side effects on
skewness and kurtosis.
The overall portfolio
standard deviation
can be reduced further
by combining both
hedge funds and
managed futures
with stocks and
bonds.
As long as at least
45–50% of the alternatives
allocation is allocated
to managed futures,
this will have no
negative side effects
on skewness and
kurtosis.”
THE RISK OF TRADING
FUTURES, OPTIONS
AND OFF-EXCHANGE
FOREX CAN BE SUBSTANTIAL.
PAST RESULTS ARE
NOT NECESSARILY
INDICATIVE OF FUTURE
RESULTS.
Disclosure Statement
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