Can hedge funds play the role? (2024)

Whether it’s a sports match or a theater production, every member of the team needs a clear and well-defined role in order to quickly identify problem areas and achieve a successful outcome. We think allocation decisions for building portfolios of hedge funds should be viewed similarly. The question is how to select the most suitable types of hedge funds for specific roles and combine them in an optimal way that creates strong alignment with the overall portfolio objectives.

To help, we’ve developed a simple and intuitive framework that focuses on the role each portfolio building block is meant to play and can help identify sources of funding from within existing portfolio allocations. Before explaining the framework, we provide a brief guide to the main strategies offered by the hedge fund industry.

Begin with the basics: Hedge fund strategy types

Hedge fund managers have a broad investment tool kit that includes the use of shorting, leverage, and derivatives and enables them to create a risk and return profile different from the underlying investments (stocks, bonds, etc.). When these tools are applied prudently, we believe they can make hedge funds a valuable addition to multi-asset portfolios.

The hedge fund industry offers a wide range of strategy types, but they typically fall into four main groups:

1. Event driven funds seek to profit from price changes that occur before or after a corporate event, such as a bankruptcy, merger/acquisition, or following the involvement of an activist investor. They typically have directional exposure to equity and credit markets, creating the potential for high returns.
2. Equity long/short funds buy stocks expected to increase in value and sell (or “short”) individual stocks or broad segments of the market expected to decrease in value. They tend to have directional exposure to equity markets, which can lead to higher volatility but also provide a good source of total returns.
3. Relative value funds seek to exploit price differences between related financial instruments, such as stocks or bonds, while maintaining low to neutral overall market exposure. This may lead to a return profile similar to an income stream, while potentially providing a differentiated source of returns.
4. Macro funds trade on trends in macroeconomic data or changes in economic policy and invest in different asset classes. The use of top-down views and instruments, as opposed to individual companies, combined with the ability to take advantage of higher levels of market volatility, leads to the potential to generate positive absolute returns when broader markets are selling off.

In practice, hedge fund managers within a particular strategy group may take very different approaches to the same goals and this should be considered when selecting funds. However, for simplicity and for the purposes of introducing our role-based framework, we will keep the focus at the strategy group level.

Every investment needs a role

Drawing on our own framework for constructing portfolios of hedge funds, we have outlined four key roles that hedge funds can potentially play:

1. Return consistency: offering steady returns that can compound over time
2. Return enhancement: increasing the overall performance of the portfolio
3. Diversification: broadening the portfolio to include additional distinct sources of return
4. Downside protection: limiting losses during significant market downturns

Figure 1 indicates the degree to which different types of hedge funds may fulfill these roles. Green indicates a hedge fund type is potentially well suited to a role, yellow signifies moderate suitability and red suggests limited suitability. Equity long/short funds, for example, could be used to pursue return enhancement but are generally not well suited for downside protection. Macro funds may provide downside protection (e.g., in more challenging equity market environments) and diversification, but generally not return consistency. And relative value strategies may be best suited to the pursuit of consistent returns, similar to a steady income stream in a portfolio.

As we discuss in the next section, we think this role-based framework can help investors be more focused when choosing individual hedge funds and determining where they fit within an existing portfolio.

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What about multi-strategy hedge funds?

In recent years, there has been growing interest among investors in multi-strategy hedge funds — most notably, funds that house multiple portfolio management teams deploying a wide range of strategies, including the four main strategy groups outlined above (event driven, equity long/short, relative value, and macro).

The objective of these multi-strategy offerings is generally to provide diversified exposure across strategy groups and potentially generate a more stable risk and return profile while also pursuing more than one of the roles described in Figure 1. Offered to investors in a single fund structure, a multi-strategy fund may combine individual strategies in a more operationally efficient, capital efficient and risk-managed way.

While multi-strategy funds may lag somewhat in certain environments (e.g., given their diversification, they may not keep up when a particular type of strategy has a strong rally), they may have a role to play for investors seeking an all-in-one solution.

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Where is the current portfolio coming up short?

We think the starting point when selecting hedge funds is to consider where a multi-asset portfolio’s current allocations aren’t fulfilling their intended roles. Figure 2 maps equities and fixed income, as well as a 60% equity/40% fixed income portfolio, to the same roles we used in Figure 1. For instance, equities are generally expected to provide return enhancement. On the other hand, investors typically seek return consistency, diversification, and downside protection from their fixed income allocations. And a 60%/40% portfolio may offer more balance across the roles, though with a primary objective of return enhancement.

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If a portfolio’s current allocations aren’t playing their role, this framework can guide decisions about which hedge funds can help and the sources of funding that will be needed to add them to the portfolio. For example, if the fixed income allocation isn’t providing downside protection, the investor can focus on choosing hedge funds that may help fill that role and using them in place of a portion of the fixed allocation (i.e., the funding source).

This framework is backed up by historical data. For example, focusing on the roles of downside protection and diversification, Figure 3 shows calendar year returns in two scenarios. First, looking at years when equities had a drawdown of more than 10%, the top chart shows that a simple 50%/50% combination of macro and relative value hedge funds (using HFRI indices) provided downside protection in almost all instances — even when fixed income did not, as in 2022. Second, looking at years when fixed income returns were negative, the bottom chart shows that the same simple combination of macro and relative value hedge funds performed well, offering a diversification benefit.

It’s important to recognize that macro and relative value funds have not always performed these roles simultaneously, so having allocations to both categories (or a multi-strategy fund that includes both) may provide a portfolio with more balance over time.

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Applying the role-based framework in practice

Finally, to help bring this framework to life, we created scenarios in which hedge funds are added to a multi-asset portfolio, replacing a portion of an existing allocation (i.e., the funding source) to help better fulfill specific roles. We assumed the starting point was a 60% equity/40% fixed income portfolio. As shown in Figure 4, we then created illustrative scenarios based on three goals:

1. Increasing return enhancement — In this scenario, the hedge fund allocation is intended to play a similar role to traditional equity, is funded from equities, and draws heavily on the equity long/short and event driven categories. There is a higher representation of the equity long/short category because it tends to have more consistent directional exposure to equity markets and it emphasizes more of the total return enhancement role.
2. Improving return consistency, diversification and downside protection — In this case, the hedge fund allocation is intended to help fill the same roles as traditional fixed income, is funded from fixed income, and focuses on the macro and relative value categories. We also think equity long/short has a small role to play, to help maintain some balance between return enhancement and return consistency.
3. Creating balance across all roles — Here, the hedge fund allocation is intended to play the roles of a traditional 60/40 multi-asset investment and is funded from both equities and fixed income. This hedge fund allocation is more diversified, with representation from all four strategy groups.

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Conclusion

We believe hedge funds can “play the role” of other multi-asset portfolio building blocks to deliver on an unmet objective, when used appropriately. We think this simple, intuitive role-based framework provides a common language that can help investors connect these building blocks across asset classes and strategy types and can be a useful starting point when constructing portfolios.

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