Traditional money management focuses on risk-adjusted returns and the importance of diversification. Hedge funds are very different. Their goal is to achieve a high-octane track record.

Leaving aside discussions about leverage, risk-adjusted returns or the “2 and 20” fees (2% management fee plus 20% of profits above a minimum threshold), you don’t sell sizzle with a low-heat setting. In fact, the sales pitch for hedge funds implies that hedge fund managers are rocket scientists who outplay traditional fund managers all the time. But, in reality, it has more to do with market segmentation than the manager’s insights.

To make the point, let’s go back to the middle of August, when Potash Corp. of Saskatchewan Inc. was trading at $115 a share. An unsolicited $135 a share takeover bid hit the market and the stock rallied well above the bid price.

Suppose a shrewd traditional mutual fund manager had thought in early August that Potash Corp. was undervalued. Cognizant of potential concentration risks, a traditional fund manager might have invested up to 3% of the fund’s assets under management in Potash Corp. shares. In short order, after the takeover bid was launched, the stock soared by 35% to $155 a share. The net impact to the fund, though, was a meagre 1.04%.

Now, look at the same trade from the perspective of a long/short hedge fund manager, who is looking for relative performance: how one sector might perform relative to another — or how one stock might perform relative to another within a sector. As long/short funds are on both sides of a trade, they can hold more concentrated positions — as much as 10% of the portfolio.

Thus, the hedge fund manager buys Potash Corp. stock in early August at $115 a share and, at the same time, sells short Agrium Inc. at $67.50 a share. Being indifferent about direction, the manager buys and sells equal dollar amounts, which means selling 1.7 shares of Agrium for every share of Potash Corp. purchased.

What effect do these trades have on the hedge fund? Agrium spiked on the takeover bid, but not to the same extent as the target. Agrium shares rallied by 12% to $75.40 when Potash Corp. rose to $155.

The short Agrium position loses 12% while the long Potash Corp. position gains 35%. Netting the positions, the trade generates a 23% profit. At a 10% weighting, the trade contributes 2.3% to the hedge fund’s bottom line — more than twice the impact experienced by the traditional mutual fund.

Therein lies the difference: traditional, long-only fund managers are looking for single base hits; no home runs. These managers are compensated for their ability to get on base and measured against traditional benchmarks. The best of the best generate above-average risk-adjusted returns.

Hedge funds focus on return optimization through relative performance metrics: more home runs, but more strikeouts. The home runs pay off with a performance bonus. The concern is that hedge funds are taking swings with your client’s money and a “strikeout” in a leveraged environment can do serious damage.

When you think about it, how you value performance — i.e., on a relative or risk-adjusted basis — is all that really separates traditional fund managers from long/short hedge fund managers. In the example above, both fund managers were shrewd stock-pickers and had added value. But, without the home-run potential, traditional funds typically rank in the third or fourth quartile compared with hedge funds — but you are comparing apples to oranges.

You should help clients understand the distinctions and emphasize that past performance disclosure carries considerable weight when examining hedge funds.

In no way are hedge funds bad. Risk-taking always has its place. But you should be mindful of the risks and limit the percentage exposure in a portfolio. Even a sizzling steak comes with some bland but necessary side dishes. IE