Personal Finance Matters How Much To Hedge   Alternative investments should be found in any portfolio, but when it comes to hedge funds, the tricky question is: at what percentage? The importance of hedge funds in a portfolio can be reflected by the continued inflows into hedge funds as seen in 2004, when they attracted $73.6 billion in net inflows, and expanded by slightly more than 18 per cent to $972.6 billion in assets under management. A research paper from Greenwich Associates noted that 32 per cent of European institutional investors now use hedge funds, an increase from 23 per cent in 2003. In addition to this, these usage and growth rates have been broadly mirrored in the US and Japan. One reason for the upsurge of interest in hedge funds is because of its historically superior risk-adjusted returns compared to traditional asset classes. This idea is set out in the table below which shows that hedge funds (as measured by the CSFB/Tremont Hedge Fund Index) outperformed equities and bonds, as well as cash, over an 11-year period with a lower risk profile, in the case of equities. Fig. 1 Annual average US$ returns (Jan 1994 – Dec 2004)   Return per cent p.a. Volatility per cent p.a. All Hedge Funds Index 11.0 8.2 Global Equities 6.1 14.2 Global Equities 7.1 6.6 Global Equities 4.0 0.5 CSFB/Tremont Hedge Fund Index has been used as a proxy for hedge funds. Returns are net of all fees MSCI World has been used as a proxy for equities Citigroup World Government Bond Index has been used as a proxy for global bonds US$ LIBOR 3 Month Index has been used as a proxy for cash Source: CSFB/Tremont, MSCI, Citigroup and Schroders Coupled with the historically strong performance, the need for portfolio diversification and protection when markets turn downward has also fuelled growth. When conducting asset allocation, it has to be recognised that the return behaviour of many hedge funds makes them appear as a separate asset class due to the fact that hedge fund returns tend to be non-normally distributed and may exhibit significant skewness as well as substantial kurtosis. However, if hedge funds are treated as a separate class, then traditional asset allocation models are likely to over allocate to them. Depending on the type and investor’s risk factors, the investment is estimated to be from five to 25 per cent. Also, look at how the addition of hedge funds could complement other holdings in a portfolio. With the addition of hedge funds, a portfolio can achieve the same level of return with a lower level of risk, or a higher level of return with the same level of risk. For a highly equity weighted portfolio, the addition of hedge funds tends to reduce risk rather than increase return, thus improving diversification. Some individual hedge funds have restrictive minimum investment requirements that prevent diversification. Also, access can pose a problem as top performing hedge funds may be closed to new monies. Many investors have been entering the hedge fund arena via the fund of hedge funds route. Unfortunately there is no neat number that an investment manager can utilise to add a hedge fund element to their portfolio. Use a tailored approach as each portfolio is considered on an individual basis together with its risk appetite. An investor can then embark on assessing the kind of hedge fund strategies it needs to achieve the desired risk/return profile. * HFR 2004 Industry Reports. Data as at 31 December 2004. This article was contributed by Schroders Investment Management.