Hedge Funds Can Offer Low Volatility

Hedge funds can provide both diversification and returns – without significantly changing the risk profile of the portfolio – as interest rates rise from historic lows.

Hedge funds are under a lot of scrutiny these days, points out a research paper by the alternatives group of Northern Trusts. Their performance is lagging stocks in 2013 and bonds over a longer period. But for institutional and wealthy investors with large exposures to fixed income, these funds have the potential to benefit a portfolio in the currrent low rate environment, and to continue providing growth when interest rates eventually begin to rise. 

Looking at historical data, the five-page paper finds that hedge funds can provide returns with volatility comparable to fixed income in a low rate environment, and significantly stronger performance than bonds during periods of rising interest rates.

When allocating, look to the future, not the past, the paper contends. While hedge funds have not performed as well as bonds or equities during the past several years, savvy investors would be wise to consider including an allocation to hedge funds in their portfolios.

Past performance is not a guarantee of future results, and weighting a portfolio toward today’s “winners” rather than following a well-diversified approach can hurt investors in the long run because various asset classes and strategies perform differently at different points in an economic cycle. It also is important to realize that the environment that led to bonds 30-year run has changed.

Bonds, the traditional low volatility asset class for many investors, have performed very well since 1981. This performance was driven by the Federal Reserve’s actions to combat runaway inflation in the late 1970s, when the Fed chose to rein in inflation by increasing interest rates to meteoric highs. The yield on the Barclays U.S. Aggregate Bond Index (BC Agg Index) reached 16.5% in September 1981 and has been on a steady decline, with a few bumps, ever since. 

Despite this recent back-up, interest rates remain near historical lows, and Northern Trusts said it fully expects them to remain low relative to historical averages for an extended period, with short-term bumps along the way. This may make achieving strong returns on fixed income more challenging. However, hedge funds, which also typically have low volatility, are able to take advantage of some of the opportunities that arise from a low rate environment. Hedge funds have historically provided portfolio diversification to investors looking to smooth out overall portfolio returns through less volatile and less correlated return streams (versus other risk assets).

A link to the paper is here, under Analysis and Research.