A recent article in the Financial Analysts Journal (FAJ) argued that, despite recent setbacks, hedge funds offer diversification benefits to the investor. Its author based the conclusion on performance measures obtained from hedge fund indices. I differ with his methods and offer an alternative view.
The FAJ Editor's Corner starts off in the right direction by trying to assess performance of hedge funds on a risk-adjusted basis. The article points out that the Sharpe Ratio of aggregated hedge fund indices has been superior to the S&P 500 since January 2009.
In my view, the Editor's Corner methodology was flawed for a couple of important reasons. It merely compared hedge fund performance to the S&P 500, hardly a comprehensive measure of investable assets. And, secondly, hedge fund indices themselves suffer from a significant self-reporting bias that inflates the returns driving Sharpe ratios.
Hedge funds theoretically have access to a wide range of financial products. Large cap US stocks such as those found in the S&P 500 are merely a fraction of their opportunity set. One would expect that managers deliver better and better performance (certainly not worse) as their range of options expands.
With that in mind, I expanded the investable benchmark to include bonds. Nothing fancy -- just used a balanced portfolio comprised of 60% of the S&P 500 and 40% of an aggregate bond index. The aggregate bond index is hardly a niche index intended to inflate benchmark returns. It includes about 80% of the US public debt market. This benchmark was a true investable portfolio as it was constructed from actual returns of a Spyder ETF (SPY) and Vanguard's Total Bond Index (VBTLX).
Two time frames were considered. The period cited by the FAJ author spanned January 2009 to the present. We used that, and also reviewed the trailing ten years
