Hedge funds are all about performance, and most hedge fund managers adopt a strategy designed to generate absolute returns (AR). Meanwhile, some investors use hedge funds as diversifiers within their portfolios. The idea is to buy a fund that has a low or, ideally, a negative correlation with stocks. Managed futures and commodities funds typically fall into this category.

However, before jumping into any of the latter funds, you need to understand the fund’s strategy and ensure that it meets your expectations. If you are looking for a diversifier, then buy gold or another basic commodity. But if you are looking for a diversifier and buy into a fund that is motivated by AR, the result may not be satisfactory.

Gold is an excellent case study, in that most investors believe it to be a good diversifier. Certainly, a small percentage of gold in a portfolio provides defensive characteristics. But hedge funds that trade gold may not be using it in a way that reduces portfolio risk. In some cases, the fund will look more like a sectoral play than a pure precious metals play.

One AR strategy is to trade gold stocks against the metal itself. Theoretically, gold stocks will track the price of bullion. Certainly, the price of bullion is a main driver of gold stocks and, on a longer-term basis, there is a strong correlation between the prices of gold stocks and bullion.

However, over shorter periods, the price of bullion can vary substantially from the price of gold-mining firms’ shares. Compare, for example, 2010’s performance data on SPDRs Gold Trust exchange-traded fund, which represents bullion, vs the shares of Barrick Gold Corp. and Goldcorp Inc.

Barrick and Goldcorp stock both traded in lockstep with bullion until the last week of April 2010. Both stocks mirrored each other and outperformed bullion until the end of July 2010. At that point, things changed, with the two firms going in opposite directions.

There are good reasons for this. Gold-mining companies have different metrics, and investors who trade gold companies’ stocks have different motivations. Traders see bullion as crisis insurance and tend to value it based on sentiment. Gold stocks tend to trade on their earnings potential and dividend outlook.

A gold-mining company such as Barrick, with its unhedged inventory and low-cost production, is leveraged to the price of bullion. Its stock will outperform when bullion prices are rising and underperform when prices are declining — which is exactly what we saw at the beginning of December 2010. Barrick stock rallied until the first week of the month, at which time it began falling much more dramatically than the price of bullion. By the third week of January, the year-over-year return on Barrick stock matched the performance of bullion almost exactly.

Now, frame those metrics in terms of an AR strategy. When we talk about AR, we are talking about long/short hedge funds for which the performance will be dictated by the spread between the long and short positions. Add leverage and conviction to the equation, and the numbers can be very good or very bad — but they will rarely track the price of bullion.

If the hedge fund manager was nimble enough to have been long Barrick stock and short bullion, or short Goldcorp stock and long bullion, at the right time, the AR numbers would have been very good. Had the fund manager taken the opposite view — say, buying bullion and shorting Barrick stock at the wrong time — the numbers would have been very bad.

That’s fine if you recommended the hedge fund as an AR strategy. But if you recommended it on the basis of the underlying asset — bullion and gold stocks, in this case — your clients would question why losses occurred at a time when bullion was rising.

In the end, knowing what a strategy brings to the table and being able to manage expectations around where it fits within a portfolio is what separates the good investment advisors from the rest. IE