Which is Risker: Hedge Funds or Index Funds?

Veryan Allen, the blogosphere's favorite hedge-fund apologist, spent New Year in Las Vegas. He's quite excited about his slot-machine returns (he won $1000 after putting in $20), which he semi-facetiously describes as "alpha". He does seem serious, however, when he says it's possible to beat the house in roulette - a statement which immediately throws into question his trustworthiness when it comes to everything else he says.

Still, he makes some good points, among them that a passive equity-only long-only investment portfolio can be far underwater for decades:

Short only equity seems to be working quite well so far in 2008 and stock indices in many major developed markets have erased most gains from last year. The S&P 500 is now around 1400 just as it was 12 months ago and in January 2000. Investors don't seem to have received much equity risk premium or been compensated for the volatility despite what the economics textbooks say but then stocks can't read. It could be worse; in Jan 1988 the Japanese Nikkei was at 24,000 and now, 20 years on, it is at 14,000. Prudence mandates acknowledging the possibility of an extended bear market and constructing a portfolio that can grow without the benefit of beta. It just snowed in Baghdad; unlikely things can and do happen.

Allen is a big basher of index funds: how do you know that equities are going to go up? He says it's much smarter "allocate to fund managers with the skill to generate reliable absolute returns". But that's the problem: if you can't even trust a broad asset class like equities to go up over the long term, you certainly can't trust any given fund manager, or group of fund mangers, not to lose your money.

If you're really risk averse, and can't afford to lose money, then there are lots of very safe fixed-income instruments available to you, including federally-insured certificates of deposit. Allen says "there is no edge in beta" and implies that anything can fall in value. Technically, that might be true, but in the real world there are some very safe investments out there with decent and certain positive nominal returns. If you buy-and-hold TIPS, you can even get certain positive real returns.

Beyond the yields available from the US government, there will always be some risk involved in your investing. But I'm far from convinced that the risk is lower in the world of hedge funds than it is in the world of index funds.