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Hedge Funds: Diversification at Any Price?

One of the key drivers of the mass adoption of hedge funds was that they provided a source of uncorrelated returns. With asset class valuations increasingly stretched, this need to diversify risk has remained as pressing as ever, but the net of fee results from hedge funds in general have been mixed.

One of the key drivers of the mass adoption of hedge funds was that they provided a source of uncorrelated returns. With asset class valuations increasingly stretched, this need to diversify risk has remained as pressing as ever, but the net of fee results from hedge funds in general have been mixed. In this context, our view is that multi-asset portfolios may provide a cheaper and simpler way of seeking risk-adjusted returns, leaving risk and fee budget for those hedge fund strategies which may genuinely offer uncorrelated returns.

Whither diversification?

We all know the big picture; after eight years of good returns and rates pinned close to 0%, valuations are stretched across asset classes. The prospective returns on government bonds given starting yields are particularly concerning, especially since bonds have performed a dual role in our portfolios providing return and diversification. Indeed, correlation between global equities and bonds has been historically low, even negative when currency effects are excluded. A pick-up in inflation and possible normalizing of interest rates may lead to a less appealing correlation environment going forward and yields at current levels may mean that the risk for bond markets is skewed to the downside. As a result, many investors could be forgiven for being concerned that they may have seen the last of the ‘sweet spot’ of declining yields and low correlation between equities and bonds.

Given this backdrop, while it would be foolish for investors to shun bond markets altogether, it makes sense for them to look to other sources of diversification and, for many, the answer has been hedge funds. Clearly this strategy is not new and several types of investors have been utilizing hedge funds for many years in the search for diversifying return streams. At this crucial juncture for investors considering how best to diversify, we provide an analysis of potential consequences of the changing dynamics of the hedge fund industry as well as the return and risk characteristics of hedge funds in the context of portfolio diversification.

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