Allocations to hedge funds should help mitigate risks

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Hedge funds trailed global equities, both for 2023 overall and in January, as investor optimism over artificial intelligence (AI) and the Federal Reserve’s policy pivot propelled equities higher. The MSCI All Country World index was up 20% in 2023, while the HFRI Fund Weighted Composite index returned 8.1%. Last month, global stocks rose 0.5%, compared to a gain of 0.4% for the HFRI.

But this is not an indication that hedge funds have failed to fulfill their expected role in portfolios, in our view. The asset class overall is never likely to match stock returns during vigorous rallies, such as the one seen since October. The primary goals of adding hedge fund exposure to a portfolio are to inject alternative sources of return and mitigate risks. Recent economic uncertainty indicates this remains important. The equity volatility last week following stronger-than-expected US inflation data provided a reminder that the market is likely to be highly sensitive to disappointing news, especially with the S&P 500 trading close to all-time highs.

Indeed, a range of economic, geopolitical, and market risks remain, and we think an appropriate allocation to hedge funds should help offset potential equity declines and offer agility to navigate the evolving macro regime. This is provided that investors are aware of certain potential drawbacks of investing in hedge funds, including illiquidity.

Select hedge fund strategies can both capture market gains and reduce market falls. With equities near all-time highs, many investors are asking themselves where to allocate excess liquidity and whether to rebalance portfolios after recent equity market gains. Historically, due to their focus on risk management and downside mitigation, hedge funds have offered a natural portfolio complement to both equity and credit, capturing upside, adding differentiated returns, and providing some protection against unexpected sell-offs. Based on Bloomberg and HFR data, the bursting of the “dot com bubble” led to a 47% fall for the MSCI All Country World index between 2000 and 2002, while equity market neutral funds lost just 0.4% and merger arbitrage shed 0.8% in the same period.

Hedge funds can increase portfolio stability and diversification. While inflation has continued to fall, the risk of stocks and bonds moving in tandem remains if it proves stickier than expected. This speaks in favor of adding a strategic allocation to hedge funds as an additional source of diversification in portfolios. The six-month rolling equity and bond correlation stood at around 0.6, similar to levels seen in 2022, when both stocks and bonds fell on rising interest rates. Separately, historical data showed moving 20% of a 60/40 portfolio from stocks to equity hedge funds would have lowered portfolio swings with little change in returns between 2000 and 2022. This smoothing can result in swifter compounding of returns and higher wealth over long-term horizons.

Elevated interest rates can also support return potential for hedge funds. We believe the Fed has clearly signaled its intention to cut rates this year. But the level of interest rates should remain relatively high, even after the 100 basis points of cuts assumed in our base case for 2024 overall. The path toward rate cuts is also likely to contribute to volatility, with the potential to widen the gap between winners and losers. This increased dispersion across securities, sectors, and countries creates opportunities for hedge funds to generate alpha and potentially achieve higher returns.

So, we continue to recommend allocating to hedge funds in a multi-asset portfolio. We currently favor low net equity long-short strategies for their potential to exploit stock pricing inefficiencies, credit long-short funds to profit from discrepancies in credit markets, and macro and multi-strategy funds for diversification purposes, as the latter stand to benefit from evolving economic and market dynamics.