Hedge funds, Alternative investments A three-point plan to build hedge funds into portfolios

CIO outlines three steps to building a hedge fund allocation, subject to their unique risks.

We believe hedge funds can help investors navigate today's uncertain markets.

• Hedge funds can provide returns that are lowly correlated to traditional stocks and bonds.
• Certain hedge funds, known as diversifiers, can mitigate portfolio losses during market downturns.
• While no guarantee of future performance, hedge fund strategies have historically delivered above-market risk-adjusted returns by capitalizing on mispricing during market dislocations.

But some investors may be reluctant to invest due to perceived challenges.

• Hedge funds can deploy complex strategies and structures that are difficult for individual investors to monitor.
• Investors require a certain experience and knowhow to select the right mix of instruments to support their financial objectives.

So, CIO outlines a three-point plan to build hedge funds into portfolios.

• First, investors can make an investment plan tailored to their objectives, risk profile, and liquidity needs. A typical hedge fund allocation might be 7% to 11% of an overall portfolio.
• Second, Invest in a “core” allocation that provides portfolio diversification and adapt to financial needs with “satellite" hedge fund investments focused on specific goals like capital appreciation or risk reduction.
• Third, reviewing and rebalancing a portfolio can help capitalize on tactical opportunities and manage hedge funds' unique risks, including illiquidity, leverage, and transparency.

Did you know?

• CIO analysis shows that adding around 10% of equity market neutral (EMN) hedge funds to a global 60% equity/40% bond portfolio can deliver comparable expected annual returns, but lower expected annual volatility by roughly 1 to 3 percentage points, respectively, based on Bloomberg data since 1990.
• In 2023, the difference between the best-performing and worst performing hedge fund strategies (HFRI ED Activists and HFRI Macro: Systematic Diversified respectively) stood at 21.8%.

Investment view

CIO believes that alternative investments, including hedge funds, should be a key component of long-term portfolios for those investors willing and able to bear their unique risks. They have the potential to help diversify return sources and smooth portfolio returns, as part of a well-diversified and multi-asset investment strategy. Investing in hedge funds may help investors diversify portfolios and exploit market dislocations. However, investors should consider the risks inherent to hedge funds before investing, including illiquidity, operational complexity, transparency, leverage, and strategy-specific risks.

Main contributors - Matthew Carter, Karim Cherif, Tony Petrov

Original report - How can investors put hedge funds in a portfolio?, 30 September 2024.