Figure 1 

A common approach has been to build a multi-manager hedge fund portfolio with bond-like volatility and minimal correlation to equities. Allocators constructing such a portfolio often focus on how to weight various categories of hedge fund strategies (e.g., Macro and Relative Value) to navigate certain market environments. But we have found that the behavioral profiles of hedge fund categories have been more similar than not in recent years, suggesting that a portfolio structured in this way may be less diversified than it appears.

Instead, we believe a style-factor lens can help allocators build portfolios of hedge funds that are more connected to the desired roles of fixed income. Here, we share some of our recent research on the behavior of our fundamental factors in different rate environments. We then explain how those insights might be applied to the process of selecting hedge funds for a multi-manager portfolio.

Finding factors that fit the roles of fixed income

As members of Wellington’s Fundamental Factor Team, we use a “role-based” framework to help us understand portfolio managers’ alpha profiles. Using this framework, we evaluated which factors best filled the roles of a traditional fixed income allocation in historical periods of large moves in interest rates (up or down).¹ Among the notable observations:

• Risk Aversion factors (capital compounder, low risk, countercyclical) were the most successful at providing downside protection across different rate environments. They also generally played a bigger role in declining rate environments, which is intuitive since large downward moves in rates have historically been associated with risk-off environments.
• Risk Seeking factors (high risk, wide range of outcomes, levered to the cycle) helped fill the role of total return enhancement in rising rate environments.
• Trend Following factors (capital appreciation, believe current trend will continue beyond the mean), which tend to be more reactive to market direction and have higher turnover, generally offered downside protection and diversification properties in periods of large moves in rates (up or down).
• A more diverse mix of factor groups was needed to fill the role of fixed income in periods of large upward moves in rates. This was likely due to the headwinds that rising rates tend to cause for many rates and credit factors.

Applying factor insights to build a better hedge fund portfolio

Having identified the factors that can potentially fill fixed income roles in specific rate environments, we analyzed the four main hedge fund strategy groups — Equity Hedge, Macro, Relative Value, Event Driven — to identify common factor profiles of funds within each group. Our high-level conclusion was that three of the four hedge fund strategy groups had relatively similar behavioral profiles, albeit with large differences in the proportion of managers with significant factor tilts. Specifically, a meaningful number of managers across Equity Hedge, Relative Value, and Event Driven strategies had long exposure to Risk Seeking factors and/or Mean Reversion factors, with some having short exposure to Risk Aversion factors as well.

We think this emphasizes the need to not be overly reliant on top-down strategy group allocations when assembling a portfolio of hedge funds. Instead, we see a case for focusing first on mapping the roles of individual hedge funds to key portfolio objectives. We think this can help mitigate the risk of having a portfolio that appears well diversified on the surface but fails to deliver a consistent profile across different market environments.

In our recent paper, “Can hedge funds behave if fixed income doesn’t? A manager-selection view”, we provide a detailed case study of how this can work in practice, including profiles of hypothetical portfolios of hedge funds designed for different interest-rate environments (Figure 2) — an illustration of the potential benefits of using a role- and behavior-based approach to increase alignment between manager research, the investment process, and portfolio objectives.

Figure 2