A portfolio is nothing more than a diversified approach to investing. More broadly speaking, there are many theories on how to optimize diversification, or how to squeeze the most return with the least amount of risk.

An early thesis, dubbed “modern portfolio theory,” was introduced by Harry S. Markowitz in 1952. MPT set out to establish a link between risk and return, then subdivided risk into market exposure and firm-specific events.

Another theory — the capital asset pricing model — emerged in 1964 and was credited to William F. Sharpe. CAPM supports the belief that a properly diversified portfolio could reduce — and even eliminate — firm-specific risk. In short, the total portfolio would deliver better risk-adjusted returns than would the sum of its parts.

Hedge funds add another layer to portfolio modelling. If MPT is market risk plus stock-specific risk and CAPM is market risk only, a stock-specific, risk-only approach is left — the strategy that equities-based hedge funds follow.

Typically, hedge funds generate their best returns in “normal” markets, in which returns fall within three standard deviations of a mean. Hedge funds often fail during “black swan” events such as the dot-com bubble and the subprime mortgage crisis. That’s not because of hedge funds’ strategy, but usually because of too much leverage.

Still, hedge funds have made their mark by delivering performance numbers that appear to fly in the face of conventional wisdom. Hedge fund managers such as Andy Soros and Julian Robertson have produced long-term returns that traditional managers such as Sir John Templeton and Warren Buffett would envy. Somehow, hedge fund managers have discovered the holy grail by finding a way to produce better long-term, risk-adjusted returns than should be possible in an efficient market.

It’s no surprise, then, that hedge funds are marketed on their returns. Rather than breaking down a hedge fund’s strategy, financial advisors talk about the prowess of the hedge fund manager. Instead of discussing the diversification benefits of using hedge funds, the industry focuses on hedge fund indices that, if taken literally, demonstrate how much added octane this segment can bring to a portfolio.

Lost in this debate is the role hedge fund strategies can play within a broader portfolio. If you seek out hedge fund strategies whose primary aim is to reduce volatility, preserve capital (i.e., limit leverage) and deliver absolute returns, then you effectively expand the assets that can be used within a CAPM-based portfolio.

Some mutual funds have gotten into this market by offering a basket of hedge funds. The mutual fund holds a number of hedge fund strategies in an effort to reduce the risks associated with any one approach. In theory, your client gains a low-risk diversifier that can be used in a broader portfolio.

The downside is the cost structure, which can exceed 4% a year, and the fact that diversification using a number of hedge fund strategies all but eliminates any high-octane performance. That’s not even mentioning the inevitable black swan event that casts a shadow over any leveraged strategy.

There may be alternatives if you believe the risk-management structure of a hedge fund is what makes it a good diversifier. To find a complementary strategy, you would seek out companies whose major source of business is risk management, such as banks.

In a sense, banks are like hedge funds, managing risks in their loan portfolios in much the same way as do hedge funds. Banks are leveraged like hedge funds — and too much leverage in the wrong market could lead to failure.

Thus, banks could be low-cost diversifiers within a traditional portfolio. That strategy would have worked quite well during the collapse of the dot-com bubble, but not during the subprime mortgage crisis. IE