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 (2003-2017)

Hedge funds increase portfolio efficiency

Source: BlackRock, Morningstar. Past performance is no guarantee of future results. Asset categories are represented by the following: stocks, S&P 500 Index; bonds, Bloomberg Barclays US Aggregate Bond Index; 60/40 stock and bond portfolio, 60% S&P 500 and 40% Bloomberg Barclays US Aggregate Bond Index; hypothetical hedge funds portfolio, 20% long/short credit (HFRI RV Fixed Income Corporate Index), 20% relative value (HFRI Relative Value (Total) Index), 20% long/short equity (HFRI Equity Hedge (Total) Index), 20% event driven (HFRI Event-Driven (Total) Index), 20% to combined global macro / managed futures (10% each HFRI Macro (Total) Index and HFRI Macro: Systematic Diversified Index), rebalanced monthly. For illustrative purposes only. It is not possible to invest directly in an unmanaged index. Diversification strategies do not ensure profits in declining markets.

Boost diversification with a multi-style approach

The term “hedge fund” designates widely different markets, strategies and tactics. A single strategy hedge fund can provide investors with one way of hedging risk and pursuing opportunity. Like any investment, there are favorable and unfavorable conditions for an underlying hedge fund style and as the chart below reveals, there can be substantial disparity in performance year-to-year.

Performance is cyclical – Why a diversified approach has the potential to lower overall risk

Yearly total returns of selected hedge fund styles

Performance is cyclical – Why a diversified approach has the potential to lower overall risk

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 2008 to 2017, where the spread was 38.9% for long/short equity hedge funds, compared to 13.9% for large cap core funds and 7.1% 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

Source: Morningstar, Lipper TASS database. Past performance is no guarantee of future results. Stocks represented by Morningstar US Large Cap Core Funds. Bonds represented by Morningstar US Core Bond Funds. Hedge fund categories represented by the following TASS fund classifications: Fixed Income Arbitrage (representing Long/Short Credit); Equity Market Neutral; Event Driven; Global Macro; Long/Short Equity. For illustrative purposes only.

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.