A traditional investment portfolio contains a combination of stocks, bonds, cash, or cash equivalents, and the mutual funds, exchange traded funds (ETFs), and managed accounts that invest in those asset classes. The goal in including multiple asset classes is to benefit from the ebb and flow of the marketplace, where certain investment categories provide stronger returns than others in some periods before the tide shifts and another category becomes the stronger performer.
The extent to which the returns of various asset classes tend to be driven by the same market forces is called correlation, and most, though not all, traditional asset classes tend to be quite highly correlated. In contrast, the returns on noncorrelated investment products, including hedge funds, aren't driven by the same factors. That means they can add significant portfolio diversification.
In fact, hedge fund returns are noncorrelated to the return on traditional investments even when the fund itself invests in stock or bonds. That's because the investment strategies that hedge funds use, including, though not limited to, arbitrage and short selling, and the extent to which their portfolios are leveraged have a significant impact on the way the fund's return is produced.
