60
September 2012 Bermuda Re/insurance
Figure 1 Equity Market Neutral
Fund-of-Funds Composite Barclays Government Credit Index Macro (Total)
Fixed Income-Convertible Arbitrage Emerging Markets: Global Distressed/Restructuring S&P 500 Index Relative Value (Total) Equity Hedge (Total) Merger Arbitrage
-40 -30 -20 -10 Percent 2008 Return Figure 2
10 12 14
0 2 4 6 8
{60/30/10 2009 Return Performance during the 2008–2009 crisis was instructive
The global financial crisis of 2008 vividly demonstrated the wide range of outcomes that different hedge fund styles can experience in extreme market environments (see Figure 1). When equities fell sharply during the crisis, funds with greater exposure to that asset class, including equity hedge and emerging market styles, were naturally among the hardest hit. As equities bounced back in the bull market of 2009, so did these styles.
Stock/Bond/Cash Mix
Meanwhile, the hedge fund styles that had provided the most protection in the previous year, such as macro, equity market neutral, and merger arbitrage, lagged significantly.
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Volatility (%)
Event Driven (Total) Distressed/Restructuring Merger Arbitrage Macro (Total)
Relative Value (Total) Fixed Income-Convertible Arbitrage
Diversifying a hedge fund allocation for better fit and efficiency Not all hedge funds are alike
Investor interest in hedge funds stems in part from a desire to reduce exposure to volatile and sometimes highly correlated markets. While most hedge funds aim to achieve positive returns across market environments, their approaches, objectives, and results can vary significantly. For example, hedge funds whose main objective is stability of returns often have little systematic market exposure which, in lieu of leverage, may result in lower overall returns, particularly in strong up markets.
Funds that seek higher returns may employ more directional beta exposure and be more closely correlated with traditional markets. Such positioning is likely to produce greater upside capture in bull markets, but greater drawdown risk in bear markets.
Emerging Markets: Global Equity Hedge (Total) Equity Market Neutral Technology/Health Care Multi-strategy
Even more important than the variations in short-term performance among hedge fund styles are their widely differing long-term risk/ return characteristics. Historically, some styles have dampened the effects of market volatility, while others have boosted returns, in part through exposure to market beta.
Using historical returns from the Hedge Fund Research, Inc (HFRI) indexes along with those of a traditional balanced portfolio, Figure 2 displays the impact of gradual increases in exposure to different hedge fund styles on a portfolio initially comprising 60 percent equities, 30 percent fixed income, and 10 percent cash. Each line represents the risk/return trade-off of adding exposure to a particular fund style in 1 percent increments, from zero to 100 percent.
As one would expect, styles that seek positive returns with
little or no systematic equity or credit market bias tend to reduce overall portfolio volatility while having a neutral to slightly positive effect on overall portfolio returns. Equity-market-neutral strategies, for example, have on average delivered significant diversification benefits relative to a traditional balanced portfolio as a result of their explicit focus on minimising exposure to various market risk factors.
This article is an excerpt from our paper, Diversifying a Hedge Fund Allocation for Better Fit and Efficiency. The paper explores the topics covered in this article more fully.
“Historically, some hedge fund styles have dampened the effects of market volatility, while others have boosted returns, in part through exposure to market beta.”
Return (%)
Hedge Fund Styles
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