Hedge Funds as Diversifiers in Institutional Portfolios (Commonfund)

August 2013

KEYWORDS: alpha, Institutional Investors, S&P 500, correlation risk, Hedge Fund Managers, portfolio diversification, risk management, Hedge Fund Research, event driven, beta, Relative Value


Kristofer Kwait; John Delano; Justin Santana, CAIA

  • Commonfund

In the not too distant past, hedge funds were often considered mysterious, exotic, and elusive investment vehicles that revealed little about their methods of generating return. As the industry has matured and standards of transparency have evolved, that perception seems to have mostly faded. Meanwhile, other broad tags of disapproval, such as that hedge funds are expensive, glorified indexers – in essence, the opposite of exotic and mysterious – have more recently taken their place. While these extremes reflect some degree of hyperbole, they also reflect legitimate concerns and important considerations for hedge fund investors: avoid investments that are inaccessible and not able to be understood; avoid constructing a hedge fund allocation that is redundant and inefficient in a portfolio. But for most, the reality of hedge fund investing is very much in-between: the inaccessibility and mysteriousness of hedge funds is often overstated, and their value as diversifiers is often understated.
• The growth of the industry has led to an increased number of correlated managers, but it has also led to an increased number of uncorrelated managers. In fact, the single largest area of growth over time has been in the group of managers with the lowest percentage of their returns explained by those of the broad equity market. For a thoughtful, strategic investor, this diversity provides the opportunity to attain portfolio diversification independent of market direction.
• The long-term, alpha-based case for hedge funds remains strong, despite recent declines in alpha coinciding with unusually adverse market conditions for security selection generally.
• In addition to significant alpha, hedge funds also offer a diverse array of systematic or market exposures.
• Hedge funds are not a monolithic entity, nor should they be considered a single and uniform investment class. They are highly diverse both among and within strategies.
Hedge funds continue to present a compelling value proposition to institutional investors as volatility dampeners, absolute return vehicles in certain cases, and as less-correlated sources of return. As an investment class they have historically demonstrated the ability to generate superior, risk-adjusted returns to the broad market. Even in periods when hedge funds underperform the broad market they still provide measurable value to a portfolio. After all, if completely confident in the direction of the market, an investor would not need hedge funds or any other source of diversification.

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