Hedge funds: an underappreciated driver of diversification 

In a rapidly evolving market backdrop, maintaining a diversified portfolio can feel like chasing a moving target. The negative correlation in the returns of traditional asset classes like stocks and bonds, once the cornerstone of a balanced portfolio, has broken down. This shift has presented many investors with a fundamental challenge around how to approach diversification when traditional risk and return dynamics have broken down between asset classes.

Beyond targeting alpha, hedge funds present a wider investment universe through exposure to a range of systemic and idiosyncratic market opportunities. Hedge funds have the flexibility to employ a broad range of tools – from short-selling and derivatives to leverage – allowing them to potentially generate returns that are relatively uncorrelated with broader market movements. 

This flexibility enables hedge funds to potentially tap into unique sources of alpha and, importantly, to adapt to market regimes. Currently, capital carries an actual cost, and we are witnessing the impacts of cash rates moving drastically higher (from historical lows) are having across markets. Importantly, these may be providing a fruitful opportunity set for hedge fund strategies, for example: 

• the capitalization of varying fiscal and monetary policies by macro and relative value strategies, 
• long/short security selection strategies exploiting high cross-sectional dispersion,
• corporate events and financial distress serving as tailwinds for credit, event-driven and activist strategies. 

All seek alpha opportunities and provide potential diversification benefits that would be difficult to replicate in traditional asset classes or through long-only strategies. 

Furthermore, hedge funds not only have lower correlation with public markets, hedge fund managers tend to also have low correlation to each other and their private markets peers, particularly when compared to long-only managers. 

In practice, this means that a well-constructed portfolio of skilled managers – in whom you have strong confidence – can be constructed around relatively uncorrelated performance drivers, strategies and exposures.

While we believe that evidence-based manager selection premised on long-term research, both qualitative and quantitative, is the most important factor in successful hedge fund investing, portfolio construction is a close second.

Hedge funds, like many skill-based businesses, are subject to a relatively high degree of attrition due to a number of factors ranging from capital losses and extended time horizons to problem resolution. The impact of this concentration risk can be mitigated by taking a portfolio approach to investing in hedge funds. 

In our view, a well-constructed hedge fund portfolio encompasses a variety of strategies and managers, thereby providing a blend of unique perspectives and skill sets. In much the same way that hiring a single balanced (stock or bond) manager does not result in a robust portfolio, no single manager has a monopoly on all good ideas. Bringing together a range of managers with robust processes and differentiated risk/return profiles is the first step to striving for effective diversification in this space.

Achieving balance within a portfolio extends far beyond simply allocating capital to different asset classes. The same principle holds true within the hedge fund arena.

A truly balanced hedge fund portfolio considers both a range of managers, and a wide spectrum of risk factors, including trading strategies, geographic reach, security types, and directional exposure (both long and short positions). Diversification across volatility regimes (long and short volatility exposure), liquidity levels, risk-taking tactics, and manager risk profiles is crucial.

Furthermore, relative position sizing of individual managers adds another layer of balance. While high-conviction managers are valuable, having multiple such managers with "too much in common" can throw off the portfolio's equilibrium. By carefully sizing each manager's allocation, investors can ensure that their portfolio remains balanced and avoids excessive exposure to any single risk factor or management style. This comprehensive approach to balance helps mitigate disappointment during market shifts and fosters a portfolio that has the potential to deliver robust, predictable, and persistent returns.

The low correlation between individual hedge funds underscores the missed opportunities inherent in an overly concentrated approach. Unlike traditional long-only strategies with high correlations, adding more hedge funds with low correlation has the potential to yield diversification benefits.

At Mercer, we believe that strategically incorporating hedge funds as "diversifying alternatives" can be a cornerstone of a well-constructed total portfolio. This approach offers the potential for both diversification and enhanced returns, ultimately leading to greater portfolio resilience and the ability to navigate evolving market dynamics. While a disciplined approach to manager selection remains paramount, we view strategic portfolio construction as a crucial element for maximizing the benefits of hedge funds and achieving alternative source of returns in the truest sense.