Begin with the basics: Hedge fund strategy types
Hedge fund managers have a broad investment tool kit that includes the use of shorting, leverage, and derivatives and enables them to create a risk and return profile different from the underlying investments (stocks, bonds, etc.). When these tools are applied prudently, we believe they can make hedge funds a valuable addition to multi-asset portfolios.
The hedge fund industry offers a wide range of strategy types, but they typically fall into four main groups:
- Event driven funds seek to profit from price changes that occur before or after a corporate event, such as a bankruptcy, merger/acquisition, or following the involvement of an activist investor. They typically have directional exposure to equity and credit markets, creating the potential for high returns.
- Equity long/short funds buy stocks expected to increase in value and sell (or “short”) individual stocks or broad segments of the market expected to decrease in value. They tend to have directional exposure to equity markets, which can lead to higher volatility but also provide a good source of total returns.
- Relative value funds seek to exploit price differences between related financial instruments, such as stocks or bonds, while maintaining low to neutral overall market exposure. This may lead to a return profile similar to an income stream, while potentially providing a differentiated source of returns.
- Macro funds trade on trends in macroeconomic data or changes in economic policy and invest in different asset classes. The use of top-down views and instruments, as opposed to individual companies, combined with the ability to take advantage of higher levels of market volatility, leads to the potential to generate positive absolute returns when broader markets are selling off.
In practice, hedge fund managers within a particular strategy group may take very different approaches to the same goals and this should be considered when selecting funds. However, for simplicity and for the purposes of introducing our role-based framework, we will keep the focus at the strategy group level.
Every investment needs a role
Drawing on our own framework for constructing portfolios of hedge funds, we have outlined four key roles that hedge funds can potentially play:
- Return consistency: offering steady returns that can compound over time
- Return enhancement: increasing the overall performance of the portfolio
- Diversification: broadening the portfolio to include additional distinct sources of return
- Downside protection: limiting losses during significant market downturns
Figure 2 indicates the degree to which different types of hedge funds may fulfill these roles. Green indicates a hedge fund type is potentially well suited to a role, yellow signifies moderate suitability and red suggests limited suitability. Equity long/short funds, for example, could be used to pursue return enhancement but are generally not well suited for downside protection. Macro funds may provide downside protection (e.g., in more challenging equity market environments) and diversification, but generally not return consistency. And relative value strategies may be best suited to the pursuit of consistent returns, similar to a steady income stream in a portfolio.
As we discuss in the next section, we think this role-based framework can help investors be more focused when choosing individual hedge funds and determining where they fit within an existing portfolio.