Hedge fund versatility brings
more opportunities

Hedge funds are pools of investment capital that have the flexibility to employ a vast range of trading strategies in both traditional and non-traditional markets. Because of this versatility, hedge funds can bring diversification to a portfolio that is hard to find elsewhere.

 


How hedge funds are different

Creating a truly efficient portfolio relies on bringing together investments that respond to market events differently. Hedge funds can enhance diversification in the following ways:

  • A broad opportunity set and fewer restrictions on investments allow more opportunities to discover investments that are less correlated.
  • Less dependence on market direction, which can help to minimize volatility.
  • Trading strategies that seek out market inefficiencies, allowing highly skilled managers to add significant value over time.

Hedge funds can help increase portfolio efficiency

Hypothetical risk/return of a 60/40 stock and bond portfolio compared to a portfolio of hedge fund strategies (2001-2015)

Hedge funds increase portfolio efficiency

Not all hedge funds are
created equal

Hedge funds rely more heavily on manager skill than broad market movements to generate returns. As a result, performance can vary widely.

Compared to more traditional stock and bond investments, there has been a larger spread between the highest and lowest returning hedge funds. The chart below analyzes the period from 2006 to 2015, where the spread was 38.1% for long/short equity hedge funds, compared to 10.0% for large cap core funds and 5.3% for U.S. core bond funds. The large variation in hedge fund returns underscores the importance of manager selection.

Huge difference between good and bad

Performance spread between top and bottom-decile managers

Huge difference between good and bad hedge fund managers

Finding a good match

Choosing a manager based on their past track record is a given, but there are other factors to consider:

  • Investment objective. What are you trying to achieve with this investment? Lower volatility? Enhanced return? Decreased correlation?
  • Structure. Will you design your own allocation or do you want a fund of funds to manage the allocation for you?
  • Team. What is the management team’s makeup, experience and culture?
  • Risk management. Is risk management an independent function that provides necessary checks and balances?
  • Operations. Does the fund have a sound operational infrastructure backed by dedicated support groups (e.g., legal, technology, due diligence) to allow the investment team to focus solely on investing?

What’s in a name?

In our view, there are five main categories of hedge funds:

  • Long/Short. Involves buying and/or selling equity or credit securities believed to be significantly under- or over-priced by the market.
  • Managed futures. Invests in global futures markets, taking long and short positions in assets such as agricultural products or precious metals.
  • Global macro. Seeks to profit from broad directional changes in securities markets, interest rates, exchange rates and commodity prices.
  • Distressed. Purchases securities of companies that are going through restructuring and looks to profit from those securities once restructuring is complete.
  • Multi-Strategy. Maintains flexibility to invest in multiple strategies at a given time.