Exploring the benefits of hedge funds 

As an asset class, hedge funds have an image problem; much like an unreliable partner, they have a reputation for being complex, high-risk and labor intensive.

The suggestion that hedge funds are an important lever within a balanced portfolio, rather than a high-octane add on, might therefore be viewed as contentious.

However, in today’s complex market environment, and indeed throughout the market cycle, we see these strategies often offering – and delivering – uncommon and much sought after characteristics. 

Across our manager research, portfolio construction and implementation, we’re seeking out strategies that, held together, can collectively deliver absolute returns equivalent to cash plus 4%, with minimal correlation to equity and interest rate risks. 

The best managers not only achieve attractive returns but do so regardless of the prevailing market conditions, delivering a protective quality to portfolios. For this reason, manager selection tends to be viewed as the most important aspect of hedge fund investing; in this article we argue that portfolio construction is a close second. 

Identifying uncorrelated return drivers

Hedge fund strategies are highly idiosyncratic, delivering wide-ranging performance through evolving market conditions, with risk appetites varying even within the same strategy type.

Hedge fund return drivers can be cyclical, meaning strategies can be impacted by market environments in different ways. For example, bi-directional security selection can be an important return driver, but relies heavily on favorable performance dispersion of individual securities – which tends not to play out during dramatic "risk-on/risk-off" moves. Getting under the skin of a manager’s core philosophy and how that plays out across the strategy is key to understanding a fund’s underlying risk drivers. 

Our research and experience suggests that diversifying hedge fund programs by return sources and implementation styles can establish a framework for potentially achieving consistent high quality returns.

By allocating capital strategically across hedge funds underpinned by uncorrelated return drivers, investors can better mitigate inherent risks and biases within their hedge fund allocation. In turn, this driver of highly uncorrelated returns supports a total portfolio's ability to navigate changing market conditions – and potential to generate attractive returns even when traditional asset classes or strategies perform poorly.

Starting at the end: manager selection

Unlike traditional multi-asset portfolio construction, we emphasize manager selection as the starting point for an allocation. Given the unique nature of hedge fund investment styles, even within a strategy type, selecting the right manager is key.

This selection process should be backed by in-depth research that accounts for and adapts to the external market environment. Once you’ve filtered the investable universe and built a short list of top  quality managers, diversification within a hedge fund portfolio needs to go beyond a simple numerical allocation across different strategies.

Portfolio construction and sizing is a meticulous process of assembling complementary risk exposures, approaches, and styles. The goal is to create a well-rounded portfolio that aligns with an investor’s overall investment objectives. By carefully weaving together managers with diverse characteristics within and across hedge fund strategies, investors can build a portfolio that is not just diversified, but strategically positioned to capture a wider range of opportunities and mitigate potential risks.

We recommend against equal weighting of hedge fund managers.  Factors such as conviction in the investment thesis, risk characteristics, the historical consistency of a manager's strategy, and how it behaves relative to other strategies should inform the allocation size.  Therefore, we propose a multi-faceted approach to position sizing, with a manager's risk profile serving as the primary determinant of the capital allocation.

We believe that the benefits of diversification found in a portfolio of hedge fund investments ultimately diminishes after a certain point. As such, we recommend that investors operate a policy of prudent concentration of between 10-20 hedge fund managers within a portfolio.

This number greatly improves the probability of success by providing some mitigation against manager mistakes, while also allowing investors to concentrate their investments in their highest conviction plays.

Going beyond manager selection

The importance of understanding the risks inherent in different hedge fund strategies and how they complement a portfolio overall can’t be overstated; a hedge fund portfolio that balances these risks is far more likely to provide reliable returns.

We advocate a balanced approach to risk within your allocation. We prioritize broad investment mandates and opportunistic management styles over narrowly focused strategies.  Multi-strategy and event-driven managers, along with credit managers employing a bi-directional approach across corporate, structured, and non-performing debt, offer a degree of flexibility and dynamism that can support consistent returns.

This approach contrasts with specialist strategies restricted to specific segments, which may be incentivized to maintain positions regardless of market conditions.

Furthermore, opportunistic managers enhance portfolio diversification by acting as a hedge against traditional asset risks while simultaneously presenting potential for alpha generation. 

We acknowledge the inherent challenges and potential pitfalls associated with tactically allocating to less liquid "alpha" strategies, sometimes with limited redemption options.  Therefore, a prudent part of constructing a long-term, strategic hedge fund program is to incorporate a high degree of opportunism at the manager and strategy level to enhance returns.

We empower our managers to opportunistically position across various risk factors and capital market opportunities. This approach avoids the top-down market timing strategies that often prove ineffective.  

A notable exception are short-biased strategies which are typically "negative carry" (meaning they incur a cost similar to an insurance premium) and have a negative expected return over time.  However, their effectiveness in risk reduction, particularly when implemented tactically, warrants their inclusion in a hedge fund portfolio.  

Overall, hedge fund allocations can be adjusted to achieve a desired portfolio-level risk/reward profile, and its composition can be optimized to balance cost and sources of return.

Importantly, a dedicated hedge fund allocation, constructed using the portfolio construction framework outlined above, can be implemented independently from the wider portfolio – meaning it can adapt to protect and drive performance, and ultimately be viewed as a reliable source of diversification across the total portfolio.

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