The promise tendered by alternative investments is that they enhance investment portfolios by providing additional diversification, thus reducing overall volatility without sacrificing returns. However, alternative investments span an extraordinarily heterogeneous range of assets. The relative merits of different alternative assets are not often explored, and our purpose here is to compare hedge funds as a general category, specific hedge fund styles and gold.
The hedge fund universe consists of very different styles that may even have incompatible objectives. Index providers have rather usefully defined these styles, and we take advantage of the CSFB-Tremont classifications for the purpose of this comparison. But although disaggregating the analysis by style does provide some useful insights, not all hedge funds sit comfortably within a particular style, and some managers may combine styles more flexibly than others. This flexibility is core to what hedge funds have to offer.
We have taken a closer look at the styles that we considered most likely to have some exposure to gold and other precious metals. Global macro hedge funds pursue directional macroeconomic strategies. Because of the positive relationship between gold and inflation and the negative relationship between gold and the US dollar, it seemed likely that this type of hedge fund would seek an exposure to gold under certain macroeconomic conditions. Managed futures, or commodity trading advisers (CTAs), are also likely to have an exposure to gold alongside other commodities. We also analyse the small but growing family of gold hedge funds.
Pension funds and their advisers may find it strange to consider gold in isolation from other commodities. Yet because of the role it continues to play as a monetary asset, gold tends to behave more like a currency than a commodity. Interest in investing in commodities is growing, and pension funds in the US and the Netherlands that already invest in commodities typically do so through the futures market. However, as far as gold is concerned, futures are certainly not the only alternative, so we based our analysis on the gold spot price, which provides a simple, transparent starting point.
We use both a statistical and a practical approach as the basis for comparison. The statistical analysis focuses on the diversification benefits and risk-adjusted returns over the period for which hedge fund data is available, ie 10 years of monthly data. The practical comparison takes into account issues such as implementation.

Statistical analysis
Our main concern here was to compare the diversification benefits provided by the generic set of hedge funds, global macro funds, CTAs, gold hedge funds and gold relative to the S&P500. Because diversification matters most when equities are underperforming, we also examined what happened during the 30 worst months of the S&P500.
Using the full data set, we found that returns on managed futures, gold bullion and gold hedge funds were least correlated with returns on the S&P500, while returns for the generic hedge fund index were actually positively correlated. Investors who prioritised protection against downside risk over higher returns would have benefited most from exposure to managed futures, gold hedge funds, global macro funds and gold bullion, ranked in order of the return correlations with the 30 worst months of the S&P 500. When stock markets under-performed, and assuming that investors had access to hedge funds, it seems they would have been better off implementing a style-based strategy rather than simply seeking exposure to the entire hedge fund universe.

Practical considerations
Implementing a hedge fund strategy raises a number of issues that do not apply to gold: opacity, size and liquidity constraints, minimum investment requirements, and moral hazard.
More than 7,000 hedge funds exist globally, most of which are excluded from the CSFB/Tremont Index because they may be too small or do not meet other requirements. A lack of transparency is a very real problem when evaluating hedge funds, but as successful implementation of hedge fund strategy requires keeping one’s cards close to one’s chest and running ahead of the pack, it seems unlikely that this particular problem will be resolved.
With respect to size, it would seem that (relatively) small really is beautiful when it comes to a hedge fund’s assets under management: in order to exploit market inefficiencies, managers need to be able to execute trades without impacting on price. The downside of small is that it may prove difficult for many investors, especially large investors, to access hedge funds directly. This is perplexing since the minimum required investment for a fund of hedge funds is said to be around £50,000. Assuming that 5% of a portfolio is to be allocated to hedge funds as an asset class, this rules out portfolios under £1m. Given the skewed size distribution of UK pension funds, for example, many potential institutional investors may find minimum investment requirements a serious constraint.
Moral hazard is a problem at two levels. When selecting individual hedge funds, how can the investor be sure that ‘it does what it says on the tin’? Is one paying active management fees for passive management performance? There is no doubt that the hedge fund community counts some of the most talented investment managers in the industry. However, historically a close network of relationships has typically provided the source of hedge fund capital, and it is hard to see how it will be possible to package the asset class for the mass market without at the same time increasing the likelihood of a market for ‘lemons’.
An obvious solution to this problem has been for investors to access hedge funds via funds of hedge funds, which resolves certain access problems but still relies heavily on the skill of the fund of funds manager. The results of this analysis have indicated that there little to be gained by simply implementing an asset-weighted strategy based on the market share of each style-based sector, given that the generic index (constructed on that basis) was found on the whole to be positively correlated with returns on equities (as proxied by the S&P 500) – a correlation that actually increased during equity market under-performance. Whichever way one looks at the issue, a degree of trust is a prerequisite, and this may sit less comfortably with institutional investors such as pension funds than
it does with ultra high net worth individuals.

The results of our analysis indicate that gold hedge funds, managed futures and gold bullion offered superior diversification over the period covered. However, taking entry barriers and liquidity constraints into account, it may prove difficult or even impossible for many investors to access hedge funds other than via funds of hedge funds. Exposure to the returns on gold bullion, whether through direct investment in the underlying metal or through the wide range of other instruments, could provide such investors with a viable and attractive alternative.
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