Hedge Funds Can Diversify a Portfolio

A white paper from the hedge fund strategies group of Commonfund shows how hedge funds can be effective diversifiers and balance equity risk in portfolios.

Investors allocate to hedge funds for a range of reasons, but a primary role of the funds is diversifying broad market risk. The paper, “Hedge Funds as Diversifiers in Institutional Portfolios,” explores key factors driving the compelling value that hedge funds offer institutional investors.

Hedge funds are not a monolithic entity, nor a single and uniform investment class, the paper contends. They are highly diverse both among and within strategies.

The growth of the hedge fund industry has led to an increase in the number of correlated managers, but it has also led to more uncorrelated managers. In fact, the single largest area of growth over time has been in the group of managers with the lowest percentage of their returns explained by those of the broad equity market. For a thoughtful, strategic investor, this diversity can provide the opportunity to attain portfolio diversification independent of market direction.

Hedge funds provide significant alpha. The long-term, alpha-based case for the funds remains strong, despite recent declines in alpha coinciding with unusually adverse market conditions for security selection generally. Although alpha is getting harder to find at the broad industry level, the best hedge funds still produce a substantial amount of alpha—and manager selection is critical.

In addition to significant alpha, hedge funds offer a diverse array of systematic or market exposures.

As an investment class, hedge funds have historically demonstrated the ability to generate superior, risk-adjusted returns to the broad market. The authors posit that even in periods when hedge funds underperform the broad market, they still provide measurable value to a portfolio because of their diversifying properties. After all, if completely confident in the direction of the market, an investor would not need hedge funds or any other source of diversification.

The white paper’s authors, all members of Commonfund’s hedge fund strategies group, are: Kristofer Kwait, managing director and head of hedge fund research; John Delano, director; and Justin Santana, director.

The white paper may be downloaded here.