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Diversification Scarcity: Teasing Out the True Value of Hedge

Hedge funds are getting a bad rap these days, and it is no wonder. The fee structure of “2 and 20” puts these alternative strategies among the most expensive available, and the recent performance record on average is uninspiring. It is not surprising to see some investors vote with their feet, including significant institutional investors that have significantly reduced or eliminated hedge fund allocations.

We believe that is shortsighted. Select hedge fund strategies can add value to portfolios, particularly in what appears to be a challenging capital markets environment going forward.

It may be helpful to go back to basics when assessing whether hedge funds make sense in a portfolio. A core tenet of Northern Trust’s investment philosophy is that “assets serve a purpose.” In other words, every asset in your portfolio should enhance returns and/or mitigate and diversify risk in service of each investor’s unique goals. It is through that simple lens that solutions and strategies must be assessed: Does a particular investment drive return, fund an impending goal or provide diversification benefits? Hedge funds can be return-enhancers and diversifiers.

Investment portfolios generally have exposure to three basic asset classes: stocks, bonds and cash. Of course, portfolios may actually own other risk assets, such as public real estate, infrastructure and high-yield bonds. However, these are simply different flavors of most investors’ primary risk asset: global equity. Unfortunately, recent analyses reveal that the average hedge fund has largely provided exposure to these traditional sources of return, and the majority of hedge funds have not offered anything unique or different. But as with everything, looking at averages can be misleading. Our research has revealed that many hedge funds can significantly contribute to investor portfolios—but choosing the right hedge funds is critical.

The primary benefit of select hedge funds is diversification. An investor’s primary source of diversification in a conventional portfolio is the exposure to high-quality bonds and cash (risk control assets) against the equity allocation (risk assets). The proportion between the risk control assets and risk assets truly defines most investors’ risk tolerance. To reduce the risk of a portfolio, simply add more bonds/cash.

Simple, right? Here is where many investors get it wrong on hedge funds. Thinking about hedge funds only as a risk reducer will set an investor up for disappointment. Why pay 2 and 20 and take on the complexity of a hedge fund allocation when an investor can just add cash/bonds to a portfolio to mitigate risk? The only reason an investor would take on the fee and complexity challenges of hedge funds would be if they offer something truly unique and different. Certain select hedge funds can provide that differentiated exposure.

Some hedge funds offer exposures to systematic risk premiums—unique and uncorrelated sources of return—that are not common to traditional long-only portfolios of stocks, bonds and cash. These alternative risk premiums have an empirically supported positive expected return and include different forms of leveraged, long-short value, carry and momentum returns across asset classes globally. But they can also include illiquidity and insurance premiums. Select hedge funds can provide a diversification benefit to an overall portfolio by capturing exposure to these uncorrelated risk premiums.         

Manager skill (alpha) can also be a unique and uncorrelated source of enhanced return and can provide important diversification benefits. Hedge funds have the tools to isolate and magnify alpha by leveraging counteracting long-short positions. When alpha represents a persistent and meaningful proportion of a hedge fund’s total return, then alpha contributes a diversification benefit to the overall portfolio similar to an uncorrelated risk premium. In this regard, alpha is a diversifier.

But high selectivity is key. Investors need sophisticated tools to tease out true skill from conventional risk. Although we find that alpha generation is uncommon on average, it does exist among a select group of hedge fund managers. High fees set up a high hurdle for alpha, which is why many hedge fund managers have been lowering their fee structures. And only select managers offer persistent exposure to diversifying, alternative risk premiums.      

Hedge fund investing is very much a “buyer beware” market. However, with the right tools and a keen focus on the proper role of hedge funds, we believe that hedge funds maintain an important place in a diversified portfolio.  

Katie Nixon is Chief Investment Officer at Northern Trust Wealth Management, overseeing $234 billion in assets under management.

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