Hedge funds for all seasons

During economic periods like we are experiencing, when financial markets exhibit increasing levels of uncertainty and volatility, investors need to look beyond generating investment returns that simply beat an equity or fixed income benchmark and consider making an allocation to the unconstrained strategies offered by hedge funds.

Over the coming years, the expectation is that long-only equity investors will endure a more challenging period and the resultant double-digit returns posted annually over the past ten years are less likely to be repeated over the coming decade. The most optimistic estimate for the classic 60/40 investor portfolio (historically regarded as the foundational investment portfolio), suggests annual returns for the next decade will be just over half that earned over the past ten years.

Given this outlook, allocating to a diverse set of investment strategies is arguably more important than ever for institutional investors faced with the twin objective of managing investment portfolio risk and delivering performance to meet the expectations of an increasing number of investors with different mandates.

A hedge fund constitutes an investment program whereby fund managers seek returns by exploiting investment opportunities, while protecting its principal from potential financial loss. An allocation to hedge funds can provide investors with more flexibility to protect and grow the capital of their beneficiaries. 

Many of the most experienced allocators no longer consider hedge funds as a separate bucket ring-fenced somehow from the traditional assets in the portfolio but as substitutes for long-only investments and diversifiers capable of transforming the risk and return characteristics of their entire investment portfolio.

Taking the first instance, where hedge funds take on the role of substitute and/or complement, investors may allocate to certain hedge fund strategies to replace some or all their investment in traditional long-only equity, and/ or fixed-income investments. Such hedge fund strategies ought to reduce the overall volatility (i.e., reduce the risk) of the portfolio’s public markets allocation with a more attractive risk-reward profile. Taking this approach should result in the capital of the investor being better preserved while the risk is also reduced.

Other hedge funds are simply too uncorrelated to equities or bonds, say, to be a straight swap since the way they behave under certain market conditions is different to the way the underlying assets of the rest of the investment portfolio behave. These are the diversifiers, providing the highest possibility of generating out-performance.

Deploying certain hedge fund strategies as a portfolio diversifier can help investors access new markets and investments that have the potential to produce out-performance and can offer a less correlated source of returns to a portfolio comprised of bonds and equities. The diversifiers comprise hedge fund strategies that are particularly uncorrelated to the underlying traditional assets in the portfolio and provide the potential for significant diversification and the highest possibility to generate out-performance. 

Combining what we have learned above, here are just some examples of how hedge fund investment strategies could positively impact an institutional investor’s portfolio in the current market environment.

Substitutes/complements:

• Long/short equity/credit hedge funds can theoretically limit the losses suffered by their investors during a downturn in equity prices. The successful management of a fully integrated portfolio of long and short positions can help increase portfolio returns even in the most difficult market conditions. Hedge fund managers that have employed the long/short strategy have proven to be very adaptable, as these funds are able to generate returns in both up and down markets as well as flat and trendless markets.
• Relative value strategies should have a broader opportunity set that can benefit from ongoing volatility and actions by central banks. Dependent on stringent fund selection, an allocation to relative value strategies could lower the risk of the overall bond portfolio.

Diversifiers:

• Trend-following strategies provide a dynamic risk-management mechanism which can help investors to avoid prolonged market downturns while participating in potential uptrends.
• Global macro funds – the unconstrained mandate of a global macro trading strategy has been proven to deliver solid positive risk-adjusted returns and has an attractive investment diversification which shares similar risk management properties to investing in a bond. Global macro funds generally exhibit a low correlation to tradition asset classes, and incorporating the strategy into a traditional portfolio has the potential to enhance the portfolio’s overall return while decreasing its risk.
• The low volatility and beta-neutral characteristics of an equity market neutral strategy have demonstrated their resilience posting steady long-term risk-adjusted returns over the long term.

To read more about how institutional investors are considering the role of hedge funds to transform the risk and return characteristics of their entire portfolios, visit AIMA/CAIA: Portfolio Transformers - Examining the role of hedge funds as substitutes and diversifiers in investor portfolios.

About
The Alternative Investment Management Association (AIMA) is the global representative of the alternative investment industry, with around 2,100 corporate members in over 60 countries. AIMA’s fund manager members collectively manage more than $2.5tn in hedge fund and private credit assets.

AIMA draws upon the expertise and diversity of its membership to provide leadership in industry initiatives such as advocacy, policy and regulatory engagement, educational programs, and sound practice guides