By: Richard Kang, Meridian Global Investors
Published: January 2005
The combination of the long position in the small cap fund and the short position in the Russell 2000 (assuming roughly equal dollar amounts) looks a lot like a market neutral long-short position, one subset of hedge funds.
Only recently, with the explosion of index funds, ETFs and alternative investments have retail investors had the tools to build portfolios in a similar manner. Like ETFs, we have also seen an explosion in the interest and money invested in alternative asset classes, especially hedge funds and so called absolute return strategies.
What investors have to understand is that passive instruments, such as the ETFs, provide a portfolio exposure to beta or market risk with the potential to receive returns. Use of alternative investments, and in particular absolute return strategies such as hedge funds aim to provide alpha and, ideally, very little beta. In other words, their returns normally aim to be determined, not by market movements, but by the active decisions made by the manager. Any changes in allocation from passive to active managers equates to a transfer of market risk to manager risk.
The combination of indexing and alternative instruments, (beta providers and alpha providers respectively) has been used by institutions for years