It's a small world, so make sure you hedge your bets

Investigates the importance of hedge funds in a shrinking world.

Following a pre-budget speech last month from Alistair Darling, the UK's chancellor of the exchequer, the FTSE 100 Index rose 13 per cent - its biggest percentage rise in a single week. Similarly, in the US, following a rescue package for Citigroup, the world's biggest banking conglomerate, and further cash injections by the Federal Reserve to revive the housing market, the S&P 500 rose almost 11 per cent, its best weekly performance since 1974. These are positive signs that equity markets are responding to the enormous financial stimuli that are being thrust at them by governments throughout the world. The big questions are, will it last, and is now the right time for investors to start increasing equity holdings? My advice is "yes", but only in the context of developing an efficient portfolio in which risk is appropriate to the individual investor. If you pile all your money into equities, you may make a lot of money over time, but there is a distinct possibility that, in the short term, you may lose even more. Here is the dilemma - how can you expose your investments to the high growth potential that equities offer without losing your shirt? The answer, as every wealth manager will tell you, is through diversification by asset type. Diversification by geographical location has some merit, but as the past 12 months have illustrated, not a lot. When the US economy takes a dive, the rest of the world usually follows suit, so spreading your money around equity markets throughout the world has not helped much because the performances are correlated. Correlation - or to be more precise, non-correlation - is the key to designing an efficient portfolio. To reduce risk or volatility in performance, you must use a combination of assets with performances that are uncorrelated, or close to being uncorrelated. According to the fund manager RMB Asset Management, the best mix of assets for a US-dollar, growth-orientated portfolio is cash (12 per cent), bonds (27 per cent), equities (24 per cent), hedge funds (22 per cent), property (7 per cent) and commodities (8 per cent). This position holds more cash than normal, since RMB has been reducing equity holdings in the past six months and is now looking for opportunities to start buying back. In the past 12 months, this strategy has outperformed the S&P 500 by 8.5 per cent and the MSCI World Index by 14 per cent - but before you get too excited, I have to tell you that it is still down 27 per cent in that period. The only asset class to buck the trend in the past 12 months has been hedge funds that use the managed-futures style of investing. This involves 24-hour computerised monitoring of equity indexes, interest rates, currency exchange rates and other securities. They take a bet on short-term movements, either up or down. This year has thrown up golden opportunities for this investment strategy, what with the rapidly falling oil prices, a strengthening US dollar and falling interest rates. Man AHL Diversified Futures, the flagship managed-futures fund from Man Investments, has performed well throughout the financial crisis and is on target to outstrip its 12-year average return of 13.4 per cent a year. In October, when equity markets were reeling, this fund returned a healthy 13.1 per cent, contributing to its year-to-date performance of 17.7 per cent to Oct 31. Superfund GCT USD, formerly Quadriga, did even better, with corresponding monthly and year-to-date figures of 24.8 per cent and 42.8 per cent, respectively. These are truly amazing results in the face of gloom and doom in almost every other corner of the globe, but, as ever, investors should proceed with caution, since hedge fund managers do not always get it right, especially if they concentrate on single strategies. Most recently, this happened when several hedge fund managers went short on Volkswagen shares, agreeing to a selling price on shares they did not own in the expectation that the price would fall and they could complete the deal at a lower price. This seemed a reasonable bet at the time, because Volkswagen's share price had remained stubbornly high when the rest of the motor industry was suffering. Unbeknown to the hedge fund managers, Porsche had been quietly accumulating shares in Volkswagen, so when the hedge fund managers were obliged to close their positions by buying shares on Germany's DAX, there were few available. When demand seriously outweighs supply, price goes up rapidly and, in this instance, it rose stratospherically. Hedge fund managers were estimated to have lost a staggering ?30 billion (Dh139.47bn). They are now crying foul, because in any other major world stock exchange Porsche would have been obliged to declare its purchases. In response, the hedge fund managers are boycotting Merrill Lynch, which assisted Porsche in acquiring the Volkswagen shares so secretly and, it is rumoured, are threatening to put a huge hole in Porsche sales by not buying so many of their cars this year. Ferrari might do well out of this. But at the retail level, where you and I operate, the situation is a lot different. The average hedge fund in October, as measured by the HFRX Index, fell by 9.3 per cent. This is nearly 10 per cent better than the performance of world stocks, as measured by the MSCI World Index. And for the year to date, the outperformance is 20 per cent. My advice is to add some hedge funds to your portfolio, building up to about 22 per cent, as recommended by RMB Asset Management. If you are intimidated by this kind of investment, start with one from Man Investments that has a large exposure to the firm's AHL Diversified programme and incorporates a rising capital guarantee. But do not be tempted to think that the strong performance of managed futures in the past 12 months justifies a wholesale shift to this class of asset. When equity markets rise, they will almost certainly outperform hedge funds. And besides, you would be losing the essential quality of the hedge fund, which is to add uncorrelated performance to your portfolio, thereby reducing overall risk. Bill Davey is a financial adviser at Mondial-Financial Partners, Dubai. For further information on this column, please contact him directly. [e-mail]