Hedge funds should no longer be treated as a separate asset class as this can mask their diversification benefits, according to a new report from two trade bodies.
The report from the Alternative Investment Management Association (AIMA) and the Chartered Alternative Investment Analyst (CAIA) Association said the strategies used by hedge funds can be distributed throughout a portfolio as subsitutes for equity or bond funds rather than sitting as a separate allocation.
“Diversification across multiple asset classes and uncorrelated sources of beta has never been more important, as global equity prices hover near fair value and interest rates remain at or close to zero.”Two of the world’s biggest pensions—the California Public Employees’ Retirement System and PGGM in the Netherlands—exited their hedge fund allocations last year, citing high costs and a lack of transparency.
But AIMA and the CAIA Association argued that investors’ approach to hedge fund investment was changing.
“The old distinctions that have underpinned portfolio construction for the last 25 years are disappearing,” said Jack Inglis, CEO of AIMA.
The two organizations highlighted several hedge fund strategies that make good substitutes: long/short equity funds, long/short credit funds, event-driven funds, fixed-income arbitrage funds, convertible arbitrage funds, and emerging markets funds.
Investors who move long/short equity hedge funds into their equity section “are not merely substituting a long-only allocation with a hedged position,” according to the report. Hedge funds’ “superior risk-adjusted characteristics over time” result in capital that is better preserved through a variety of market conditions, AIMA and the CAIA Association argued.
And if a fund is not a good substitute, it is a diversifier, the report added. While all hedge funds offer diversification, there are some strategies that are “particularly uncorrelated to the underlying assets in the portfolio,” the organizations said.
The report claimed strategies such as global macro, managed futures/CTAs, and equity market-neutral offer “significant diversification and the highest possibility of generating outperformance.”
“Diversification across multiple asset classes and uncorrelated sources of beta has never been more important, as global equity prices hover near fair value and interest rates remain at or close to zero,” said William Kelly, CEO of the CAIA Association.
Although how an investor should allocate to hedge funds will vary by mandate, AIMA and CAIA argued the key was not to target a specific percentage—for example, 15% or 20% of the total portfolio. Instead, investors should view hedge funds as another method of investing within their existing asset class allocations.
“This new thinking promises to transform the risk and return profiles of institutional investor portfolios,” Inglis said.
Related: Hedge Funds and the Price of Consistency & Concentration Beats Diversification, Study Finds