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Figuring where hedge funds fit; Portfolio planning for the very rich

Todd Builione, a managing partner at Highbridge Capital Management, a $15.7 billion hedge fund that is majority-owned by JP Morgan Chase, uses a baseball metaphor to describe the growth of assets involved in alternative investments. ''Somewhere between the third and fifth inning'' of the nine-inning game, he said.

According to Douglas Wurth, global head of alternative investments at JPMorgan's Private Bank, $1 billion a month is flowing into hedge funds on JP Morgan's platform, where wealth managers are now recommending that very rich individuals (worth $25 million or more) and institutions put 35 percent of their portfolios into alternatives and 20 percent of that into hedge funds.

Wurth and Builione were speaking together with a panel of other senior executives from the Private Bank and it was clear that alternatives continued to be the rage for a number of reasons, including the fact that hedge funds have traditionally had low correlations with major equity and bond markets. In other words, when those markets tank, hedge funds, in general, do not.

Then there is Ray Dalio.

Dalio, the founder of Bridgewater Associates, a hedge fund with about $30 billion under assets, has some different thoughts on his industry, including some tough questions on why hedge fund returns look so much like stock market returns when they are not supposed to be correlated.

In a private research letter sent out this month, he and a colleague examined the correlation of hedge fund returns with the market returns of certain market indexes.

In general, hedge fund returns should not replicate stock market returns. If they did, investors would be smarter to buy index funds and not pay the steep fees of hedge funds.

Because hedge funds can hedge their bets, take on leverage, tread where others fear to tread, and seek out nontraditional assets, they should generate excess returns not just reflect market returns.

According to Dalio's analysis, over the past 24 months, hedge funds were 60 percent correlated with the Standard & Poor's 500-stock index, 67 percent correlated with the Morgan Stanley Capital International EAFE (for Europe, Australia and the Far East) index of foreign shares, and 87 percent correlated with emerging market equities (unhedged). They were 41 percent correlated with the Goldman Sachs Commodity Index, 52 percent correlated with high-yield, or junk, bonds, and 42 percent correlated with mortgage-backed securities.

The letter also parsed the correlations by strategy, which is a more precise way to think about hedge funds, since different types of funds take different kinds of risks. Short-biased hedge funds have a negative 70 percent correlation with the S.& P index, while equity long-short, the description applied to what most people think of as a hedge fund (betting on stocks that might go up and others that might fall, usually with leverage) had a huge correlation of 84 percent.

Then Dalio looked at data back to 1994 and showed that historical correlations were in the range of 49 to 54 percent - high, but not as high.

So as equity markets have done well, hedge funds have done well - not necessarily because of their genius but because they have the wind of the stock markets at their back and because a lot of them use leverage to magnify their bets.

Dalio did not return calls asking for comment.

Still, no one cares about correlations, or anything else really, until the markets head down.

But a lot of investors like Bridgewater as a part of a diversified group of hedge funds because Dalio has a contrarian view and because if and when the markets tank, he should - and he had better - trounce his more correlated peers.

And Dalio clearly has more than his powers of prognostication on the line: Bridgewater returned a meager 3.4 percent last year.

Many people in the asset management world think the whole correlation thing is overblown: Of course hedge funds will take advantage of strong markets to make money. The key is that when the markets turn, these managers can do something about it. The question is whether they are smart enough to know to do it.

And maybe they are. But investors would be smart to try to understand how exposed they are to the markets that they might think they are well protected against.

(Private equity firms, another popular place to dump money these days, are buying highly leveraged large-cap companies).

Of course, understanding returns may be hard. Wurth of JP Morgan expressed concern about aspects of hedge fund investing, notably the lack of transparency, which makes it harder to monitor trading by fund managers, and the lack of influence a single client might have on a big fund. That is why clients are limited to 35 percent, even though many want their portfolios to look more like those of foundations and endowments, which can have as much as 60 percent of their assets in alternative investments.

''You do things that foundations don't do,'' Wurth joked. ''You die and you pay taxes. So don't get ahead of yourself.''