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OBJECTIVE

Hedge funds are also noncorrelated to traditional investments such as stocks and bonds. Noncorrelation means that there is no correlation between the two. If stocks are down, hedge funds could be up, down, or flat; there is no correlation pattern. This is not the same as negative correlation. Negative correlation means if the stock market were down, hedge funds would be up.

Thus, by putting 5 to 10 percent of an investor's portfolio into hedge funds, the investor obtains portfolio diversification. This is especially valuable when stock and bond markets are not favorable, are flat, or are choppy.

Hedge fund managers' goal is to provide superior returns under all market conditions. Hedge funds are not designed to outperform the stock market in a roaring bull market but rather to shine in flat, negative, or choppy markets. Over the past decade, we've seen a roaring bull stock market. In general, most hedge funds lagged the stock market by a few percentage points. This is because they are hedging by using either options or futures for protection against the downside. This is similar to an insurance cost they must pay during a roaring bull stock market.

However, it is the down markets or the choppy, volatile stock markets that we saw in 2000 that is the best environment for most true hedge funds.

During the roaring bull stock market of the 1990s, it was believed that some hedge fund managers, in an attempt not to get left behind in the performance game, lifted their hedges and were exposed to the stock market more than they should have been. During the periods when the stock market fell, it was possible to examine the performance of managers and see whether this was true.

For example, in February 1999, the S&P was down 3.1 percent; 78 percent of the hedge funds did better than the S&P that month, and 44 percent of the hedge funds were positive that month.4

Or in April 2000, the S&P was down 3 percent. About two-thirds of the hedge funds did better, and 41 percent were positive.5

And in November 2000, when the S&P was down 7.9 percent, 80 percent of the hedge funds outperformed the S&P.6

In August 1998, when the S&P fell 14.5 percent, 75 percent of the hedge funds did better than the S&P; 23 percent of the hedge funds