Hedge funds: A renewed role in modern portfolios 

That was certainly found to be the case among some of the largest investors in the world. In Mercer’s Large Asset Owner Barometer 2025¹, surveying asset owners with a combined AUM of over $2 trillion on their sentiment towards the key risks to their portfolios and subsequent asset allocation decisions, we saw a 14% year-on-year increase in net expected allocations towards hedge funds/absolute return strategies.

It is fair to say that some investors might still look unfavourably on hedge funds due to past concerns around "underperformance". The reality, though, is that this perception may stem, in large part, from misaligned comparisons and outdated assumptions. In the current interest rate environment, amid shifting portfolio construction needs, the hedge fund landscape makes for an interesting proposition.

One of the most persistent misconceptions about hedge funds is that they consistently underperform equities. However, we believe, this comparison is flawed. Comparing a lower-risk, diversified approach to hedge fund investing to higher-risk assets like equities sets unrealistic performance expectations and may often lead to misinformed portfolio decisions.

Instead, hedge funds may be more appropriately compared to fixed income, as a diversified hedge fund programme is designed to generate a "cash plus" return — targeting base rates plus a performance premium with only moderate volatility.

The shift to a higher interest rate regime has had profound implications for capital markets and portfolio construction. Notably, it has diminished the diversification power of traditional fixed income, which for decades acted as a counterbalance to equity risk.

With their ability to invest in both long and short positions across a variety of asset classes, hedge funds may offer an alternative avenue to diversification. They are well positioned to provide potential downside protection, mitigate portfolio volatility, and take potential advantage of market dislocations — all attributes that are increasingly important in today’s environment.

Volatility has re-emerged as a key market characteristic, driven by inflationary pressures, geopolitical uncertainty, and unpredictable fiscal and monetary policy shifts. While such an environment can unsettle traditional asset classes, it can create fertile ground for hedge fund strategies through nimble positioning and active risk management. This makes them particularly valuable in a “higher-for-longer” rate setting where both equity and bond markets may be more vulnerable to policy shifts.

The normalisation of interest rates has introduced a true cost of capital, which is beginning to reshape company valuations and capital allocation decisions. For hedge fund managers, this has created potential opportunities to exploit mispricing and inefficiencies through long/short equity strategies and distressed debt. Businesses that may have once thrived under free-flowing capital are now facing pressure, and this divergence is creating a robust opportunity set.

We believe to truly unlock the potential of hedge funds, though, investors should focus on portfolio construction and manager selection. One of the most common mistakes is over-concentrating allocations in one or two hedge fund managers. A robust hedge fund allocation typically comprises multiple managers, pursuing complementary strategies and offering varying risk-return profiles. This “prudent concentration” approach balances diversification with the opportunity to express high-conviction views through manager selection.

The goal is not to chase equity-like returns but to complement existing allocations with tools that can help navigate uncertainty, reduce risk, and potentially enhance long-term outcomes. In a world where traditional asset class relationships are evolving, we believe hedge funds are becoming increasingly important to achieving diversification within an investment portfolio.