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Hedge fund risk?

Hedge fund risk? While some opine on hedge funds speculating us all into financial meltdown, a rearguard action has recently emerged accusing funds of not taking enough risk. As with most endeavors, if you are being criticized by both sides, whatever you are doing is probably correct. Most hedge funds are less risky than traditional equity funds and if a manager does not see opportunities for the strategy he should not invest for its own sake.

Most hedge funds target returns investors need - a RELIABLE performance somewhere above 10% per annum, EACH and EVERY year. They are prepared to give up some potential upside to reduce downside risk. The absolute return, hedging and risk management skills are what matter, not outperforming some arbitary stock index.

Another critique is that hedge funds often hold significant cash; the decision to hold cash is important yet some less enlightened investors think funds should fully invest, complaining of paying hedge fund fees for simple cash management. Occasionally, I go fully 100% to cash when I consider rewards are unlikely to compensate for the possible risks. Why? Because that's the job.

Take a typical hedge fund aiming for 15% a year at 10% volatility and no drawdowns worse than 5%. If a fund of funds, or any investor for that matter, wants higher returns, just borrow and lever up the performance to almost any level, within reason. Use 2x leverage and, assuming you can borrow at 5%, to get fund returns of 25% at 20% volatility and 10% drawdowns. Why ask the underlying fund to increase risk?

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