3 Ways Investing in Hedge Funds Can Boost Portfolio Performance Based on Financial Goals

Investing in Hedge Funds Can Accomplish These 3 Performance Goals for Your Portfolio

Thinking about investing in hedge funds? Evaluating hedge fund performance is challenging because it involves many different investment strategies, employed by thousands of funds across a global $3.32 trillion industry. While many investors will analyze a previous track record to help determine which funds they should choose, that approach rarely leads to a great investment experience. As most investors know all too well, past portfolio performance is not necessarily indicative of future results.

Instead, investors are often best-served to consider one very basic question: “What am I looking for when investing in hedge funds?” Ultimately, hedge fund investors are seeking one of three things for their portfolio:

1. Capital preservation
2. Portfolio diversification
3. Return enhancement

Consider which one of these financial goals you’d like to meet. Depending on the goal, there are a variety of strategies when investing in hedge funds that can help improve your portfolio performance.

1. Capital Preservation

Investors seeking “capital preservation” should lean towards larger, established hedge funds that can invest in multiple markets and can deploy capital across many different strategies around the globe. These funds can provide hedge fund investors with capital protection while still delivering strong risk-adjusted returns over time.

These types of hedge funds tend to be less reliant on the general direction of bond or equity markets to drive their returns. Instead, they have more of an “all-weather” profile with the goal of generating consistent performance and lower volatility, or less drawdown risk.

Within traditional markets, fixed income, such as certificates of deposits or government issued bonds, often provides investors with enough capital preservation. However, certain investors may be concerned about the instability of current interest rates and their potential to rise steeply in the next year or two after hitting an all-time low in 2020. Indeed, the National Association of Realtors expects mortgage rates to  raise just over 3% in 2021. When rates rise, bond prices fall, thus eliminating the intended benefit of protecting capital in fixed income.

Instead, certain hedge funds can help “fill the void” that fixed income may create. These hedge funds can take on the role of providing the preservation of capital within a diversified portfolio.

 2) Portfolio Diversification Away from 60/40 Allocation

Typically, traditional investments in a combination of stocks and bonds provide sufficient portfolio diversification during normal market conditions. When investors have 60% of their portfolio in stocks and 40% in bonds, it is referred to as the “60/40” allocation approach.

The rationale is simple: equities tend to appreciate over time, as do bonds—albeit to a lesser extent. But when equities decline, as they did last year, bonds represent a “flight-to-safety” exposure and function as a diversifier within the portfolio.

Although interest rates are predicted to remain relatively low this year, there is still a vast amount of uncertainty surrounding the global economy in 2021. Certain investors may be concerned about the possibility of equities declining while rates rise, potentially leading to negative performance in both stock and bond markets. In that environment, investors may not be adequately diversified. Fortunately, there are certain portfolio performance strategies that act as diversifiers to a more traditional portfolio.

For investors seeking portfolio diversification, they should consider discretionary macro strategies. These have shown the lowest correlation to traditional markets over the past two decades. Macro hedge funds typically invest in different markets, based largely upon a manager developing a fundamental view of the macroeconomic environment and investing accordingly. For example, a macro hedge fund manager might think that the U.S. dollar is going to outperform the Japanese Yen, or that a certain commodity like gold, Bitcoin or oil is likely to rise or fall in line with their expectations for global inflation.

These types of investments are very different than traditional stocks and bonds. They offer hedge fund investors an opportunity for portfolio diversification, allowing them to introduce new exposures within a portfolio that is traditionally closer to 60% equities and 40% bonds.

3) Flexibility for Return Enhancement

Historically, equity markets have been the “engine” of portfolio returns. However, there have been periods when equities have generated low (or even negative) portfolio performance over many years.

Following the 10-year bull market in equities, investors saw a challenging environment for long-only equity investments in March of 2020. And while the bear market bottomed out last year, and the market once again returned to bull market territory with the S&P 500 rising 52% in Q3, the volatility has many investors wary. Indeed, as equity indexes continue to soar, the stock market may be headed for another crash.

For investors seeking flexibility for return enhancement, investing in hedge funds may be the right call. When it comes to hedge fund performance, there are three ways in which a hedge fund investor can achieve enhanced returns and seek to take advantage of the flexibility that hedge funds have over long-only strategies:

1. The first is when the hedge fund uses a specialized focus, either geographic, sectoral or factor-based (e.g. value or small-cap) to generate returns from a long and short perspective. Over time, portfolio returns will come from specific company exposures rather than broad market direction, driven by a dynamic portfolio construction and strong risk management.
2. Co-investments offer another way of enhancing returns, allowing investors to participate alongside a hedge fund in a single investment idea. Fund managers will occasionally have a specific “high conviction” investment in which they offer investors the opportunity to invest alongside the manager. These co-investments are typically within a single company or a specific theme that has a discrete time horizon (typically one to two years). This type of co-investment can benefit investors by charging lower fees than a typical fund investment.
3. Thirdly, hedge fund investors seeking to enhance portfolio performance can focus on accessing smaller hedge funds that have historically delivered outperformance versus their larger peers. Strategically, these managers tend to focus on long/short equity and event-driven strategies and can invest in more “off-the-radar” securities that larger funds cannot readily access.

Considering the significant contribution to returns that equities have provided over the past decade, as well as the protection from bonds and the negative correlation between the two asset classes, investors may feel as though they are well-positioned. And from a return enhancement, capital preservation and portfolio diversification perspective, they are.

However, as market volatility continues to increase, so does hedge fund performance. By considering their financial goals when investing in hedge funds, investors have an opportunity to improve overall portfolio performance and quality over time.

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[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Due Diligence Before Investing; PE, VC, and Hedge Funds De-Mystified; Personal Finance & Investing Fundamentals 2.0. This is an updated version of an article originally published May 29, 2018 ]

©All Rights Reserved. January, 2020.  DailyDAC^TM, LLC d/b/a/ Financial Poise^TM