The hedge fund strategy that makes the best addition to a long-term, diversified investor’s portfolio is relative value – at least according a new working paper from a finance professor and an economist at the U.S. Securities and Exchange Commission.
The paper, authored by Massimo Guidolin of Milan’s Bocconi University and Alexei Orlov of the SEC’s economics and risk analysis division, examined whether hedge fund strategies were beneficial to otherwise diversified, long-horizon portfolios – and which ones provided the most benefit.
For the purposes of the study, “diversified” meant a portfolio of stocks, government and corporate bonds, and real estate investment trusts. The hedge fund strategies under consideration for this portfolio were based on ten different HFR indexes: fund-weighted composite index and fund-of-funds composite index, each representing the entire hedge fund universe; the equity hedge, event driven, global macro, and relative value indexes, representing four main hedge fund strategies; and their sub-strategies including equity-market neutral, merger arbitrage, distressed restructuring, and fixed-income convertible arbitrage.
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Modeling the ideal portfolio for a range of risk preferences, Guidolin and Orlov determined that not all hedge fund strategies have potential to benefit long-term investors, noting that those that are difficult to replicate yield the highest gains relative to an investor’s risk tolerance.
While relative-value hedge funds were found to be the “best viable option,” other good strategies included merger arbitrage, distressed restructuring, and convertible arbitrage.
Meanwhile, equity-based strategies such as equity hedge and equity-market neutral were generally shown to offer less benefit.
But the worst option, according to the study, was funds-of-funds. “A long-horizon investor should refrain from investing in funds of funds,” the authors wrote, noting that investors in funds-of-funds were “excessively penalized” by the double layer of fees.