Demystifying hedge fund investment

Higher returns, downside protection or diversification benefits – what role do hedge funds play in a portfolio? The answer could be any one of the above, or even all three.

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 and liquid alternatives, as their more liquid and transparent versions are also known, have become a notable feature of the financial landscape.

Such strategies have seen their assets under management soar to over USD4.5 trillion.Source: HFR, as of 31.12.2024 Hedge fund strategies (including macro, long/short equity, equity market neutral, event-driven and relative value) comprise a multitude of sub-strategies leaving investors with a variety of risk/return profiles to choose from.

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 mispricing 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.

Hedge funds aim to deliver returns across various market conditions. Yet it is perfectly reasonable to expect the return of, say, a long/short equity strategy to be much worse – or much better – than that of a macro strategy or an equity market neutral strategy under the same market conditions.

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 funds serve as substitutes, capable of replacing a portion of equity or fixed income investments to improve the overall return-volatility trade-off.

An analysis of the returns EMN funds have delivered since 2000 shows such strategies have offered investors a considerable degree of protection from market falls; the correlation of their returns to those of the market has also remained low.The figures given here are taken from the most widely used hedge fund indices produced by HFR. Although it is well-known that these indices have a number of limitations, they nevertheless offer a reasonable representation of the aggregate returns of the strategies investors can access. The analysis presented uses the HFR Index and its sub-sectors as a proxy for hedge fund returns. HFR Indices are designed to capture the breadth of hedge fund industry returns across all strategies and regions. The HFR Indices used are equally weighted and their returns are reported net of fees. For government bonds the correlation has been around zero; for equities it has averaged 0.4, while equity beta – a measure of the sensitivity of hedge funds’ returns those of the stock market, is below 0.1.

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 0.47 per year since 2000, allocating just 10% of that capital to the average market neutral strategy would have lifted that figure to 0.50, thanks to a considerable reduction in volatility.

The benefits of diversification are particularly valuable during tough years – in 2022, when balanced portfolios lost an average of 18%, the addition of a 20% diversifier would have reduced that loss to 14%, according to our calculations.

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 (2000-2024), 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 market corrections of the past two decades, LSE funds offered investors a far greater degree of capital protection.

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 5.8% per year in US dollar terms since 2000; the volatility of that return would have amounted to 15.5% annualised.

Yet by replacing 10% of this portfolio’s capital with an allocation to a long/short directional strategy, the yearly return is unchanged yet the volatility falls to 14.8%. What’s more, the return per unit of risk increases with every incremental increase in the LSE allocation.

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 central banks continue cutting interest rates, for instance, adding an EMN investment to a bond allocation can enhance the portfolio's yield. If the opposite occurs and rate cuts undershoot expectations, pushing up bond yields, EMN strategies can provide fixed income investors with a way to mitigate the risk of capital loss. Given their portfolio construction, EMN portfolios also contain a large proportion of cash, which would provide a further tailwind to returns in a higher interest rate environment.