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 organisation’s needs and objectives.
Potential benefits of hedge fund investing
DiversificationHedge 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 convexitySome 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 profileHedge 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.
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 minimising the impact of broader capital markets. This means hedge fund managers can use tools and methods not usually employed by more traditional managers:
ShortingThis 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.
LeverageAsset 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.
DerivativesFinancial instruments such as equity futures or collateralised loan obligations give asset managers access to differentiated sources of risk and return.
Private investmentsAsset managers often have the ability to access non-listed assets, substantially broadening their potential investment universe.
Increased concentrationPortfolios often consist of as few as 10-15 investments, magnifying the impact of each one on the overall strategy’s performance.
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