If recent reports are to be believed - and they certainly carry the odour of truth - the Hong Kong Monetary Authority intends to start speculating with public money. It could be making a big mistake. According to a report in yesterday's Financial Times newspaper, the monetary authority is planning to put some of the Exchange Fund's reserves into 'alternative investments', which means high-octane stuff like private equity and hedge funds. 'A jolly good thing, too,' you might say. 'It's about time the Exchange Fund started earning a bigger bang for its bucks.' Indeed, at first glance the authority's move has a lot to recommend it. But the closer you look, the more it becomes clear that it is making a lousy decision. The Exchange Fund's mandate is simple. Its main job is to run the 'backing portfolio' that underpins Hong Kong's exchange rate peg to the US dollar. This entails holding enough high-quality and highly liquid US dollar assets - which basically means US Treasury bills and notes - to fully back Hong Kong's entire monetary base, which as of yesterday was just over HK$1 trillion. On top of that the Exchange Fund manages its own accumulated surplus, which was worth HK$553 billion at the end of December last year, together with the government's fiscal reserves, which are worth a further HK$508 billion. These two pots of money are lumped together in the 'investment portfolio', which has traditionally been invested in developed-country stocks and bonds in order to preserve the portfolio's value in inflation-adjusted terms. Anywhere else, this stash would be called a sovereign wealth fund. But as Hong Kong is not a sovereign entity, let's call it our public wealth fund instead. In recent years the HKMA has come under criticism for the investment portfolio's lacklustre returns. In response, it appears to have come to the conclusion that it should follow other sovereign funds and diversify its portfolio by allocating money to alternative investments like private equity and hedge funds. Once upon a time, this sort of diversification made good sense. Indeed, way back in 1990, US economics professor Harry Markowitz picked up the Nobel prize for pointing that adding alternative, non-correlated, assets to a traditional mix of stocks and bonds could increase a portfolio's returns without raising its level of risk. As a result, investors began including non-correlated assets like hedge funds - which in theory can make money in falling as well as rising markets - private equity funds and commodities in their portfolios. But there was a problem with the theory. Back in the early 1990s, hedge funds, private equity and commodities were uncorrelated with traditional assets because they were niche businesses, sitting well outside the mainstream investment world. However, as more and more mainstream institutions sought to diversify their portfolios by pumping funds into alternative assets, the inflows meant that those assets became increasingly correlated with each other - and with traditional markets. Take hedge funds. Traditionally, they made their money by being smart and nimble enough to jump on mispricings that conventional investors either missed or were unable to exploit. But as the number of hedge funds proliferated, the mispricings were soon arbitraged away, forcing hedge fund managers to leverage up and take on ever more risk, for example, by buying illiquid subprime assets, just to earn the same returns. When their credit lines were cut in 2008, they found themselves forced to sell liquid assets like stocks all at the same time, exacerbating the market crash and inflicting punishing losses on their investors. Similarly, as private equity funds expanded, attractive investments became increasingly hard to find. As a result, the funds simply took on more risk, which led to disastrous investments like Cerberus Capital Management's multibillion US dollar takeover of GMAC, the financing arm of General Motors, which later had to be rescued by the US Treasury. Diversification into alternative assets is a myth. If everyone tries to do it, it doesn't work any more. If the grandees that advise the Exchange Fund don't believe that, they should take a look at the chart below, which shows the performance of different asset classes over the last three years. The red line is the HFR global hedge fund index, the black line is the S&P 500 index of US blue chips, and the blue line is an index of US Treasury note returns. Over the last three years, hedge funds as a group have lost their investors just short of 10 per cent. That's better than US stocks, which are down almost 18 per cent, but nowhere near as good as US treasuries, which are up 23 per cent. Investing in hedge funds has provided no diversification benefits that could not be replicated by holding a mix of US stocks and treasuries, which is pretty much what the exchange fund's investment portfolio owns anyway. Gauging private equity returns can be tricky, but if you take the performance of stock in Blackstone - one of the managers the HKMA is said to be considering - as a proxy and add it to the mix, the picture looks even worse. Blackstone shares are down more than 50 per cent over the same period. In short, speculating with public wealth fund money on hedge funds and private equity is a lousy idea. It won't add much by way of diversification, but it will add a lot of risk. The HKMA should scrap the whole plan.