One of the primary differences between traditional and hedge fund investments is that, for hedge funds, it is the skill of the manager (‘alpha’) rather than the performance of a market or an asset class (‘beta’) that drives returns.
Traditional asset managers generally allocate capital on a ‘long-only’ basis to stocks, bonds and cash. Portfolios are managed against a passive benchmark which they aim to outperform. The relative weighting of positions tend to have little deviation from the benchmark itself, resulting in very similar return profiles. Consequently, this makes it difficult for traditional managers to make money when markets are falling.
In a financial framework, the term ‘hedge’ can be defined as ‘guarding against risk of loss’. As such, any suggestion that hedge funds are riskier than traditional investment strategies may be misguided, especially considering that the long-only approach has fewer options to protect itself from the fundamental risk of market downturns.
The underlying philosophy of the hedge fund industry is that, the skill of the manager (‘alpha’), rather than the performance of a market or asset class (‘beta’), should principally determine the success of the strategy. This key difference is also reflected in the performance-related remuneration of managers and the freedom that they are given to invest in a much broader range of financial instruments and assets.
Hedge fund managers employ a diverse and constantly evolving range of trading strategies to generate returns. Therefore, hedge funds can provide opportunities to manage risk as well as diversify in both bull and bear markets.
- Traditional Investments
- Restricted opportunity set
- Mainly dependent on beta
- Relative return objectives
- Flat fee structure
- Limited diversification sources
- Inefficient dispersion of risk
- Hedge Funds
- Can exploit wide range of price distortions
- Focused on alpha generation
- Target consistent performance
- Alignment of manager/investor interests
- Large number of strategies
- Enhanced risk/reward trade-off