Are hedge funds a seperate asset class?

Hedge funds are proving to be very popular with investors in New Zealand and around the world at the moment.

Two of the key questions advisers and investors should be asking are: Are hedge funds a separate asset class and how should they be included in a well-diversified portfolio?

Frank Russell's Tacoma-based manager of investment policy and research Andy Turner is quite clear that hedge funds are not a separate asset class.

To determine whether an investment type, or group, can be called an asset class it needs to be compared against six key criteria.

1. To be an asset class the investments need to be conceptually similar securities. He says hedge funds fail this test as they can include a wide away of securities, including equities, bonds, currency, commodities etc.
2. There needs to be high correlation between the various investments within an asset class. Again hedge funds fail, primarily for the same reason they failed the first test. Hedge funds can include a wide range of securities, consequently there is little correlation.
3. The asset class, or wannabe asset class, has to be material. Turner is in no doubt that hedge funds are material as there is more than US$1 trill invested in the area. If debt, or leverage, is included the figure is probably considerably higher.
4. An asset class has to have a good set of available and reliable data. Turner says one of the problems with hedge funds is that much of the data is either missing or at best suspect, so it's impossible to make comparisons on a level footing. (More on this later).
5. An investor should be able to invest passively in an asset class, that is buy an index. "Dream on," Turner says about hedge funds.
6. The final characteristic of an asset class is that it has to be something new, and exclusive. Turner says hedge funds don't pass this test as they are just another way of investing in the so-called traditional asset classes, such as shares and bonds. "Hedge funds are double counting a significant number of other assets."

On Turner's count hedge funds only pass one of these six tests, so they can't be considered a separate asset class.

"They don't stack up very favourably." Turner says.

How then, should an investor include hedge funds in a diversified portfolio?

Turner's view is that because hedge funds aren't an asset class they shouldn't be used in a strategic asset allocation.

"We think (hedge funds) are out in terms of your strategic asset allocation," he told delegates at Frank Russell's Australasian conference last week.

Although Turner raises some concerns about hedge funds from an asset allocation point of view, he is not saying don't use them.

"For some people we think these are a good idea."

Those investors maybe ones who have larger percentage of their money in equities.

For people who don't have a lot of shares, they there are better, more risk controlled options for ramping up returns.

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