Investing in hedge funds 

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May 10, 2023

Investing in hedge funds can provide an important source of diversification from both a risk and return perspective. 

Hedge funds are actively managed investment pools in which managers use a wide range of strategies, providing diversification relative to both equity and interest rate risk with minimal give-up in return. Hedge funds are not an asset class on their own. They are funds invested in listed equity, listed bonds, private markets, and commodities, meaning grouping them together is inappropriate when trying to build them into your portfolio.

We refer to hedge funds as ‘diversifying alternatives’, a term we believe encapsulates what these kinds of funds are designed to add an important element of diversification to your portfolio through a variety of different strategies. Essentially, these strategies give you a risk-controlled exposure to non-traditional sources of return. We believe an optimum alternatives allocation should include a long-term strategic allocation to unconstrained hedge funds that is matched to your organization’s needs and objectives.

Potential benefits of hedge fund investing 

Given that different hedge funds can invest in a variety of asset classes in different ways, there are a number of potential benefits to your portfolio from establishing an exposure across the different classes.
  • Diversification
    Hedge funds can provide your portfolio with alternative sources of return and different risk exposures by accessing asset classes in unconventional ways, such as shorting, and greater use of derivatives and leverage. 
  • Asymmetry or convexity
    Some hedge fund strategies are designed to capture positive returns in all market environments. You may have heard these strategies called ‘absolute return’.
  • A high-quality return profile
    Hedge fund strategies can carry high risks, but they are usually designed to target a return that compensates for this in as efficient a way as possible.

Managing a hedge fund allocation: What is the recipe for success?

The key to hedge fund portfolio construction is not unlike the key to any successful portfolio comprising stocks, bonds or multi-assets—a disciplined approach and effective diversification.

Hedge fund strategies and approaches 

Hedge funds can give you access to alternative risk exposures alongside your more traditional allocations to equities, real estate and bonds. Hedge funds take alternative approaches to these and other asset classes to find new sources of returns that seek a premium over other asset classes by taking different types of risk.

Asset managers of these strategies can use a wide range of investment approaches to generate these differentiated returns, as well as minimizing the impact of broader capital markets. This means hedge fund managers can use tools and methods not usually employed by more traditional managers:

  • Shorting
    This allows asset managers to seek profit from an asset or security falling in price by selling a stock then later buying it back at a lower price. Asset managers often pair up securities in an effort to profit from one improving and the other declining.
  • Leverage
    Asset managers can borrow money from banks to expand the size of their portfolio and potentially enhance their returns. This approach can also magnify any losses.
  • Derivatives
    Financial instruments such as equity futures or collateralized loan obligations give asset managers access to differentiated sources of risk and return.
  • Private investments
    Asset managers often have the ability to access non-listed assets, substantially broadening their potential investment universe.
  • Increased concentration
    Portfolios often consist of as few as 10-15 investments, magnifying the impact of each one on the overall strategy’s performance.
Some specialist asset managers may also seek out specific types of situations in which to invest, such as mergers and acquisitions or distressed companies.
Critical thinking, critical issues

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