Breaking through the barriers of portfolio efficiency 

Hedge funds are not an asset class, but rather a collection of heterogeneous investment strategies which can be utilised to gain exposure to a variety of non-traditional risks. They have the potential ability to simultaneously diversify equity market beta and interest rate duration risk. As such, hedge funds are uniquely qualified as a true diversifier, warranting a strategic long-term allocation rather than being viewed as a short-term tactical opportunity.

The very unconstrained nature of hedge funds and dispersion of risk profiles across the universe means these strategies can be positioned to serve nearly any role across the risk/reward spectrum. Regardless of the application, we believe hedge funds have the potential to offer three core benefits:

• Diversification: from systemic risks which dominate traditional portfolios, equity market beta and interest rate duration.
• Asymmetry: less constrained mandates and a broader toolkit, which allow trade and portfolio construction that emphasise upside asymmetry, ultimately in pursuit of consistent compounding returns. 
• High-quality return profile: an improved Sharpe ratio, lower beta and positive alpha compared to a 60/40 portfolio.

At Mercer, we mostly position hedge funds as a risk reduction mandate, targeting annual returns of cash plus 3% - 4% over a complete market cycle, and importantly, through a return profile that is complementary to the rest of your portfolio without sacrificing return potential. 

When constructing a hedge fund portfolio, it is important to prioritise manager selection first and foremost, across a diverse group of strategies.  The first step should be to identify skilled, top-tier managers who have a competitive advantage and are likely to achieve future success. These factors should drive allocations within each strategy as opposed to seeking managers to satisfy pre-defined strategy targets. An asset allocation should be established to include a diverse blend of strategies, risk exposures, and approaches that complement each other and the broader portfolio. It is important to note that not all managers should be equally weighted in the portfolio. Position sizing plays a crucial role in hedge fund portfolio construction, as it allows for multi-dimensional diversification, relative risk weightings, conviction expression and ultimately room for error when done properly.

Lastly, we caution against narrow portfolios or shortcuts in any part of the process. In our experience and backed by third party research, a well-rounded hedge fund allocation and one that achieves the proper level of multi-dimensional diversification mentioned is likely to consist of 12-15 underlying manager allocations. A level of prudent concentration in position sizing can further help balance the benefits of concentration (maximising the value proposition of manager selection) and the benefits of diversification (minimising the impact of manager mistakes), while avoiding the risks of concentration and over-diversification.

The post-Global Financial Crisis (GFC) era reminded us that the alpha environment and the effectiveness of alternative strategies are heavily influenced by capital markets, government policies, and the macroeconomic environment. The implementation of zero interest rate policies after the GFC, extended during the pandemic, disrupted the investment landscape, and created a risk-on environment. Investors were compelled to take on higher risks, directionality, and beta, in a belief that “there is no alternative” (TINA). These policies induced herd behaviour, dampened the business cycle, and reduced correlations, dispersion, and volatility across global markets. As a result, traditional assets experienced one of the most prosperous periods in history, while diversification strategies were ultimately punished.

Despite the challenges faced by hedge funds employing bi-directional strategies with limited beta, they demonstrated remarkable resilience while highlighting their long-term performance potential. 

However, the current and foreseeable future environment is vastly different. Significant changes in the macro environment, geopolitical risks, and global policies have shifted the headwinds faced by hedge fund strategies to tailwinds. We are witnessing the end of TINA through increased volatility, higher dispersion, dynamic correlations, and pockets of dislocations, all against a backdrop of higher interest rates. 

We believe hedge funds are well-positioned to take advantage of the extensive opportunity to generate alpha in today’s rapidly evolving landscape. They offer a unique return profile and serve as a bridge between public and private markets, making them a valuable addition to investment portfolios. As traditional assets face challenges and the dynamics of stock-bond correlation shift, hedge funds have become an essential component for investors seeking diversification and higher returns. Our current capital market assumptions support this view, as we think there may be significant outperformance compared to traditional fixed income investments and lower risk compared to equities in the next decade. 

When wealth managers are new to investing in hedge funds, they often begin with an outsourced discretionary approach. As they become more experienced, they may opt for a more hands-on approach, such as an extension of staff solution which can be tailored with custom levels of control, oversight, and operational complexity.  Experience, comfort level, and resources ultimately determine direction of implementation. Regardless of the approach, given the complexity and nuances of managing the allocation through a portfolio within a portfolio approach, we suggest wealth managers closely partner with their adviser on their hedge fund allocation. In our experience, a close partnership can help ensure the programme stays on track while providing comfort of dual oversight and contributions. We touch on these approaches below. 

Discretionary

For wealth managers who recognise the benefits of hedge funds but have limited expertise, resources, or time, a discretionary solution is ideal. This approach offers access to top-tier managers, strategies, and diversification typically found in institutional settings. It is particularly suitable for those who prefer professional guidance and implementation through discretionary engagement or a directed programme with veto authority. It also offers benefits of scale, efficiency, and often speed of implementation.

Extension of staff

For wealth managers who have experience of hedge funds, it may be beneficial to consider an “extension of staff” approach. This approach is ideal for those who regularly review their alternatives portfolio and are comfortable using a wide range of investment options. With this approach, wealth managers can maintain control over key investment allocation and implementation decisions while receiving support in the form of new manager ideas, best practices in portfolio construction, in-depth analysis of investment strategies, and access to research through desktop tools. This advisory relationship allows flexibility to meet needs and responsibilities while also allowing for knowledge transfer over time.