Hedge funds represent the future of active management, and that future will consist of two complementary elements: (1) hedge funds that offer alpha and (2) index funds that generate the benchmark rate of return or perhaps some alpha in a disciplined manner. Combined, these two approaches will replicate and eventually replace traditional active management. But first, hedge funds must shake off certain negative characteristics of their current behavior and embrace some necessary changes.
- Hedge funds should exist to take sources of expected return, such as idiosyncratic skill (alpha) and nontraditional arbitrage (hedge fund beta), and turn them into separate investable assets.
- Hedge funds should not be an expensive stock market index fund with a few shorts thrown in for credibility.
- Not only are hedge funds here to stay; the market model of the future could likely be a combination of index funds and hedge funds.
- Institutionalization of hedge funds, with its pros and cons, is definitely under way, although best practices for both investors and managers require serious improvement.
- Risks and issues abound in traditional markets (long-only stocks and bonds), so if a time ever existed to look for nontraditional sources of return, the time is now.
When investing in hedge funds, investors expect a combination of positive expected returns, alpha and diversification of risk through low to zero correlation with traditional asset classes. The hedge fund world does not always achieve such low correlations, but certainly that is one of its primary goals.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.