Overview
The years since the bursting of the US credit bubble have forced investors to reassess many of the approaches and assumptions they previously held dear.
High-grade sovereign and corporate bonds, for example, can no longer be considered reliable sources of income. Not only do vast swathes of the fixed income market trade at negative yields, but government bonds have, on several occasions, proved exceptionally volatile. ‘Flash crashes’, as the US Federal Reserve itself has observed, are likely to a permanent fixture in US Treasury markets.
Then there are stocks. Equities have experienced fits of volatility with alarming regularity. Many consider this a testament to the explosive growth of algorithmic trading and passive investing. But whatever the cause, this has left many investors with steep investment losses that have been difficult to recover.
And all the while, the correlation between stocks and government bonds – asset classes that rarely moved in lockstep prior to the Great Recession – has tended to spike whenever central banks step up or scale back their monetary stimulus efforts.
The upshot is that portfolio construction has become a more complex process. It is increasingly difficult to diversify the sources of a portfolio’s risk and return simply by combining fixed income and equity assets. Investors have been looking elsewhere for sources of diversification and more stable returns.
Portfolio construction has become a more complex process. It is increasingly difficult to diversify the sources of a portfolio's risk and return simply by combining fixed income and equity assets.
A possible solution to this problem is an allocation to hedge funds.
Hedge funds offer investors a way of securing returns that are beyond the reach of traditional long-only bond and equity portfolios. They typically use a range of advanced investment and risk management techniques to control volatility and deliver returns that are independent of the market cycle.
In recent years, hedge funds, or liquid alternatives as they are also known, have become a notable feature of the financial landscape.
Such strategies have seen their assets under management more than double in the past 10 years to some USD3 trillion.1 The eVestment database for institutional investors and consultants now tracks more than a dozen different hedge fund strategies, including macro, long/short equity, equity market neutral, event-driven and relative value.
Yet having such a wide range of options is not quite as desirable as it seems. Although most hedge funds invest in established asset classes such as equity, bonds, loans, commodities and cash, they differ considerably in the extent to which they combine long and short positions, deploy leverage and use derivatives to generate alpha.
They also vary according to the type of market anomaly they seek to exploit.
For example, some strategies aim to take advantage of the mis-pricing of securities within companies' capital structures or between instruments, regional markets, and industry sectors through various arbitrage strategies. Others focus on predicting company-specific developments such as mergers and acquisitions that have the potential to trigger large moves in individual stock or bond prices. The rich variety of options can be problematic for investors.
Faced with such complexity, prospective hedge fund investors naturally struggle to make an informed choice. But there are ways to chart a course through this challenging terrain. One way is to look at the functions these alternative investments can perform within a portfolio.
This commentary aims to shed light on the functional properties of hedge funds. Specifically, our analysis builds on a growing body of evidence that shows such strategies can broadly play one of two roles in a balanced portfolio.
Some serve as diversifiers. These are strategies whose returns exhibit little or no correlation with those of mainstream asset classes and can therefore alter the risk-return characteristics of an entire portfolio. Other types of hedge fund serve as substitutes, capable of replacing a portion of equity or fixed income investments to improve the overall return-volatility trade-off.