Hedge funds sometimes get a bit of a bad rap. The people who run them are often characterized in the popular imagination as greedy, and amoral exploiters of the loopholes in the market economy. It is then with undisguised glee that some critics point to the sector’s paltry returns over the past decade compared to just holding a long position in the S&P 500.
But really, to disparage hedge funds for underperforming a stock market index (during an extraordinary bull run) is to potentially misunderstand their role in a diversified investment portfolio. Not many hold hedge funds as the core part of their portfolio. The alternative strategies they employ are literally meant to provide a hedge— using multiple different investment strategies in an effort to balance each other out.
Alternative strategies themselves are not so much an asset class as a set of tools for managing portfolio risk and return. These tools include the use of leverage to amplify small differences in an underlying asset’s value, short selling to benefit from declines in the price of securities, derivatives to play off probabilities and arbitrage in the midst of major corporate transactions. The aim of these strategies is to generate a return that is market-agnostic—that is, units of an alternative fund can just as easily gain value in a bear market as in a bull market.
Having exposure to alternative strategies may do several positive things for a portfolio that’s primarily invested in stocks, bonds and real estate. Where your core investments may already be diversified by asset class and geography, alternative strategies add another layer of diversification by the use of strategy.
Uncorrelated to the stock and bond markets, they can reduce the amount your account gets drawn down in a correction or crash—meaning it can take less time for your portfolio to recover and may have a head start on reaching new heights. Further, they typically tend to be less volatile than the stock market so that even if the return doesn’t match that of the S&P 500, their risk-adjusted performance may remain competitive.
Institutional investors such as pension funds are increasingly incorporating alternative strategies into their portfolios to not only potentially obtain these favourable risk-adjusted returns, reduce their losses in a market crash and increase their scope of diversification; they’re also looking for greater flexibility to respond to unique investment opportunities as they arise and the ability to customize portfolios for the unique needs of their members and owners.
Nicola Wealth offers its clients the same benefits with its Nicola Alternative Strategies Fund. In subsequent blog posts, we’ll look at how some alternative strategies work and why we feel they are particularly important at this stage of the business cycle. To some, they still may feel exotic and risky. But they’re really about reducing the volatility of a portfolio, something every investor can appreciate.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is intended for tax residents of Canada who are accredited investors. Residency restrictions apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.