Introduction

As institutional investors focus on ways to diversify a traditional 60/40 portfolio and generate a higher share of returns through alpha rather than beta, hedge fund allocation has emerged as a timely topic. This paper aims to provide a holistic framework for hedge fund allocations and discuss practical considerations when building and actively managing a hedge fund portfolio.

Investment inherently involves risk, but today's macroeconomic and market landscape presents an especially uncertain and challenging environment. After reaping the benefits of globalisation, low and stable inflation, and falling interest rates for years, we are now witnessing a regime shift – escalating geopolitical tensions and fragmentation, along with structurally elevated inflation, interest rates, and market volatility. All these make asset allocation via long-only return streams across both public and private markets more challenging.

Here, we find that hedge funds offer a unique value proposition by deriving returns from both long and short positions and dynamic investment strategies. Given these characteristics, as well as the heterogeneity within the hedge fund universe, a well-designed and actively managed hedge fund portfolio can provide resilience and alpha across various market conditions. As such, we expect hedge funds to play an increasingly important role in institutional portfolios as a tool to help mitigate losses, enhance macro resilience, and improve risk-adjusted performance.

Our proposed hedge fund allocation framework combines top-down asset allocation considerations with bottom-up manager selection, along with robust and proactive portfolio construction and management. As illustrated in Figure 1, the framework comprises three components:

• The first component adopts a top-down total portfolio perspective, defining the roles that hedge fund allocation is expected to fulfill and determining the desired allocation ranges for different types of hedge funds.
• The next two components take a bottom-up perspective, highlighting crucial areas that are often neglected when selecting managers and managing the hedge fund portfolio on a day-to-day basis.
• Together, they comprise a comprehensive process and generate insights essential for building a successful hedge fund allocation.

This paper consists of three sections:

First, we identify the primary attributes (low correlation, capital preservation in equity drawdowns, and alpha generation) that investors typically seek from hedge fund investments and assess the degree to which hedge funds have demonstrated these traits. We observe that over the past decade, hedge funds have shown the potential to deliver on these three attributes. However, there is considerable variation among hedge funds, even within the same general strategy classifications commonly employed in the hedge fund industry. As such, using these standard strategy classifications to build desired hedge fund portfolios may not be the most effective approach.

Second, we propose a different approach to categorise hedge funds based on the three attributes mentioned earlier. We identify four distinct sub-groups of hedge funds with unique risk/return profiles, that span different strategy classifications. We demonstrate how the optimal hedge fund mix differs based on the investor’s target role for hedge funds in the portfolio. To illustrate, we examine two roles: (1) a standalone hedge fund allocation with attractive risk-adjusted returns, and (2) a hedge fund allocation that is integrated into a 60/40 portfolio to enhance total portfolio risk adjusted returns. We find that a standalone allocation would allocate to higher beta hedge funds to achieve higher returns, while an integrated allocation would lean more toward low beta, diversifying hedge funds. While the integrated hedge fund allocation has lower returns than the standalone allocation, it reduces total portfolio risk, which can be monetised by adding risk assets like equities to the portfolio. We also discuss an alternative to taking more beta risk to achieve higher returns, which is to add leverage to a suite of less correlated managers. 

Finally, we delve into key considerations when taking a bottom-up perspective, focusing on manager selection and portfolio management. We believe that the success of a hedge fund allocation relies heavily on both process and experience. While this last section is not exhaustive, it serves to illustrate the breadth behind a long running hedge fund investment programme. 

This document is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction. Any examples used are generic, hypothetical and for illustration purposes only.