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hedge funds' role in a portfolio

July 2020

The long, the short and the neutral: uncovering hedge funds' functional properties

Long/short and market neutral strategies can play a key role in portfolio construction.



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.


Substitutes vs diversifiers

A feature common to virtually every alternative investment is its ability to alter the risk-return profile of all or part of an investor’s portfolio. Of the many hedge fund strategies available, we believe that two stand out as having demonstrated their transformative powers over several market and economic cycles: equity market neutral (EMN) and long/short equity (LSE).

Portfolio diversifiers

As their name suggests, EMN strategies do not depend on market moves to generate their returns. Managers of EMN strategies construct ‘market neutral’ portfolios by holding an equal proportion of long and short positions; they can also use derivatives to reduce their investments’ beta and correlation with the broader market to negligible levels. When executed well, this ensures that investment managers’ security selection skills become the primary source of return.
Fig. 1  - Market neutral strategies offer protection against capital loss, favourable risk-adjusted return
Return, indexed, market neutral funds vs global stocks
Return, indexed, market neutral funds vs global stocks

Source: MSCI, HFR. Returns in US dollar terms, covering period 31.12.1999-31.03.2020

An analysis of the returns2 EMN funds have delivered since 2000 shows such strategies have offered investors a considerable degree of protection from market falls; their beta, or their volatility relative to that of the overall market, has remained low – 0.0 and 0.1 versus government bonds and global equity respectively – as has the volatility of those returns.
Fig. 2 - Market neutral strategies can diversify risk
Balanced portfolio: return, volatility with/without allocation to equity market neutral strategy, 2000-2020
balanced portfolio

Source: MSCI, Citigroup, HFR. Returns in US dollar terms, monthly rebalancing, balanced portfolio gross of fees; data covering period 31.12.1999-31.03.2020

Offering a combination of low beta, low correlation and low volatility, EMN can play a clearly-defined role - that of a diversifier of risk and return for a portfolio composed of bonds and stocks. This is shown in Fig. 2. While a typical balanced portfolio would have delivered a risk-adjusted return of 0.40per year since 2000, allocating just 10 per cent of that capital to the average market neutral strategy would have lifted that figure to 0.43, thanks to a considerable reduction in volatility. 

Equity substitutes

LSE strategies are designed to deliver returns that are similar in magnitude to – but less volatile than – those of mainstream equity markets. They take both long and short positions in stocks, but tend to remain ‘net long’ with the aim of both generating positive returns when the market rises and of preserving capital when it falls.

Put differently, their returns stem partly from a controlled, and actively-managed, exposure to beta - the return attributable to the market - and partly from alpha, the return that stems from the security selection skills of the investment manager.

In our analysis of the most recent market cycles (2000-2020), we find that LSE strategies enjoy certain advantages over mainstream global equities.

As Fig. 3 shows, capital losses for LSE funds are much shallower when financial markets fall, while their returns are – on average – less volatile over the long run. During the major bear markets of the past two decades, LSE funds offered investors a far greater degree of capital protection.

Fig.3  - Long/short equity strategies offer protection against market falls
Return, indexed, long/short equity vs global stocks, 2000-2020
Return, indexed, long/short equity vs global stocks, 2000-2020

Source: MSCI, HFR. Returns in US dollar terms, covering period 31.12.1999-30.03.2020. MSCI World Returns are with net dividends re-invested

Because of these attributes, LSE strategies are able to perform a specific function within a diversified portfolio: they can serve as a substitute for some or all of the equity allocation. As Fig. 4 shows, investing in global equities would have secured a return of 3.2 per cent per year in US dollar terms since 2000; the volatility of that return would have amounted to 15.3 per cent annualised.

Yet by replacing 10 per cent of this portfolio’s capital with an allocation to a long/short directional strategy, the yearly return is unchanged yet the volatility falls to 14.5 per cent. What’s more, the risk-return trade-off improves with every incremental increase in the LSE allocation.

Fig. 4 - Allocations to long/short equity can improve volatility-adjusted return of equity portfolio
Return, volatility, %, of equity portfolio with varying allocation to long/short equity, 2000-2020
Annualiased return volatility

Source: MSCI, HFR. Returns in US dollar terms, monthly rebalancing, data covers period 31.12.1999-30.03.2020. MSCI World Returns are with net dividends re-invested

Bond substitutes

When it comes to substitutes for a fixed income allocation, the most conservatively-managed EMN strategies are viable options. That’s because such funds can generate volatility-adjusted returns that are superior to those of government bonds, the typical anchor for a diversified portfolio. What is more, their addition to a government bond allocation can deliver benefits throughout the interest rate cycle. Should low interest rates persist, for instance, adding an EMN investment to a bond allocation can enhance the portfolio's yield. If the opposite occurs and bond yields rise, EMN strategies can provide fixed income investors with a way to mitigate the risk of capital loss.

Combining diversifiers and substitutes

Combining diversifiers and substitutes

As LSE and EMN possess different functional qualities, the two strategies can be used together in the same portfolio. To see how, we compared the long-term return of a traditional 60 per cent equities and 40 per cent bonds investment to those of balanced portfolios that included allocations to a combination of LSE and EMN strategies.
The analysis shows that even a small allocation to these types of hedge funds can materially improve the portfolio’s volatility-adusted return. For instance, replacing 10 per cent of the portfolio’s total investments with an allocation to market neutral strategies and substituting 20 per cent of the equity portion with LSE increases the annualised volatility-adjusted return to 0.49 from 0.40.
Fig. 5 - Combining diversifiers and substitutes
Combining diversifiers and substitutes

Source: MSCI, Citigroup, HFR. Returns in US dollar terms, monthly rebalancing, balanced portfolio gross of fees; data covers period 31.12.1999-30.03.2020


A health warning

While hedge funds can play an important role in a diversified portfolio, their effectiveness depends on the skills of the investment manager. And as many investors have discovered to their cost, investment professionals are not equally skilled. Tellingly, the dispersion of returns among individual hedge funds is far higher than that of long-only funds.3

Complicating matters further, as many as 10 per cent of all hedge funds close every year.4 This illustrates that alternative investments require deeper scrutiny than their traditional, long-only counterparts. Effective due diligence rests on three pillars.

First, investors must establish a deep understanding of the source and sustainability of a hedge fund’s returns. This would give a clearer – and hopefully more realistic – view of the magnitude of returns such strategies can generate and the time period over which these might materialise. Finding hedge fund managers that are able to achieve superior returns year in, year out requires extensive research and skill, as well as careful qualitative and quantitative analysis.

Second, prospective investors should also have a thorough understanding of the risks a hedge fund is exposed to. Identifying sources of risk is perhaps even more important than analysing sources of return. Having a clear view on the amount of leverage a strategy deploys, the liquidity of its underlying investments and the counterparty risks to which it is exposed is vital.

Third, investors must assess the transformative powers of a hedge fund investment. In other words, they need to be confident that their allocation delivers an outcome that is in keeping with their long-term investment goals. At the same time, it is also essential to determine whether adding a hedge fund to a portfolio might demand deeper changes in its asset mix.


Concluding remarks: hedge funds and strategic asset allocation

Offering sources of return not readily available in long-only investment strategies, hedge funds have traditionally been viewed as a distinct asset class, one that merits its own separate allocation within a diversified portfolio.

Fig. 6 - Hedge funds: their role in a diversified portfolio

But in familiarising themselves with the functions such strategies can perform, investors will see hedge funds in a different light. This analysis has shown that hedge funds possess a number of functional properties – they are, in effect, specialised tools that protect capital, control volatility and reduce a portfolio’s sensitivity to shifts in the financial markets. Hedge funds should be therefore be seen as either as an actively-managed diversifier for an entire portfolio or a substitute for investors’ bond or equity allocation.