Total assets under management for the hedge fund industry reached an all-time high of $2.6 trillion in 2013.[1] With lower expectations for traditional assets, many institutional investors, including pension funds and corporates, are lending an increasing allocation to alternative assets to secure both performance and resilience for their portfolios. As a result, hedge funds are now growing faster than any other type of asset. They are expected to reach $3.3 trillion by 2015 with compound annual growth rates of around 15%.[2]

This 11th Lyxor white paper looks at hedge funds from a new perspective, in the context of strategic asset allocation (SAA). We see the growth of the assets managed the industry as an implicit consequence of the different approach taken with regard to hedge fund investments.

Numerous studies using pre-2008 data have shown the benefits of adding hedge funds to SAA. Hedge funds were previously considered to be a stand-alone asset which should account for a small percentage of overall portfolios. Now, in the aftermath of the financial crisis, a new paradigm has appeared: hedge funds are becoming mature investment styles exhibiting significant and persistent performance divergence both with each other and when compared to traditional assets.

As such, hedge fund strategies should be disaggregated into sensible sub-categories which should naturally migrate from a stand-alone asset into the broader equity and bond asset mix. In this context, we propose a reassessment of the relationship between hedge fund strategies and traditional markets to introduce an updated SAA framework with hedge funds.

To highlight the above points, the paper addresses the following structural questions:

• What are the stylised facts of hedge fund performance in the post-2008 environment?
• How should we classify hedge funds in order to better reflect their true characteristics?
• What is the best way to integrate the new classification process into a SAA approach?

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Alternative investments, including hedge funds, have grown faster than non-alternatives and have now surpassed their 2007 levels. For this reason, institutional investors expect to increase allocations to alternative classes, especially hedge funds. It seems that many investors are still following the traditional approach to examining their strategic asset allocation (SAA) with hedge funds because many academic and empirical studies are based on pre-2008 data. As the performance of hedge funds is becoming less homogeneous than in the past, it is of the utmost importance to re-examine the SAA with hedge funds.

In our investment philosophy, hedge funds can be regarded as (equity or bond) beta providers or pure alpha generators. Intelligent use of beta-provider hedge funds allows more efficient risk diversification compared to traditional assets.

Moreover, it is worthwhile to introduce some pure alpha-generator hedge funds to generate uncorrelated absolute return. To take advantage of these benefits, we propose a new process for classifying hedge funds into two families: equity/bond substitutes and diversifiers. To take into account economic periodicity, we then propose a regime switching mean-variance model for determining the hedge fund allocation in strategic asset allocation.

A new vision after the sub-prime crisis

• Hedge funds are more resilient than traditional assets during crisis periods.
• In the post-2008 environment, it is no longer possible to consider hedge funds as a single asset class.

Many academic studies show that hedge funds are generally more resilient than equities and bonds in extreme periods, with hedge fund losses being three times lower than the largest falls suffered by equities. In addition, hedge fund returns are very positive in comparison with the biggest losses made by bonds. Moreover, several studies report homogeneous attractive hedge fund performance for almost all hedge fund strategies using data from before the sub-prime crisis in 2008. This homogeneity allows investors to consider hedge funds as a single asset class in strategic asset allocation.

Nevertheless, many differences between strategies appeared during the sub-prime crisis period. For instance, equity hedge strategies suffered from big losses whereas macro fared better. The difference between hedge fund strategies in terms of performance and volatility has persisted since 2008.

Classifying heterogeneous hedge funds
We can classify hedge funds in two groups:

• Substitutes, which aim to replace equities and bonds in order to improve portfolios’ risk/return profiles;
• Diversifiers, which aim to generate absolute performance and diversification.

When we break down hedge fund returns into beta return and alpha return, we can see that some hedge funds have more significant beta return than alpha return and vice-versa. We can therefore categorise some hedge funds as equity/bond substitutes (more significant beta return) or diversifiers (more significant alpha return) according to the breakdown of hedge fund returns. Substitutes aim to improve the risk/return profile of traditional assets (equities or bonds) whereas diversifiers generate absolute performance and diversification.

This classification process is described in Fig.1 and the classified hedge funds can be found in Table 1.

Smart strategic asset allocation
Much research using hedge fund data from before 2008 uses a simple Markowitz mean-variance framework to study the problem of allocating hedge funds in SAA. Nevertheless, due to the non-normal distribution (asymmetric and/or fat-tailed) of hedge fund returns, a simple Markowitz mean-variance framework will likely lead to an inefficient portfolio composition and also underestimate tail risk. One possible solution consists in getting rid of the non-normal distribution of hedge funds by considering a Markowitz mean-variance framework with regime switching. In addition to the investment philosophy of smart strategic asset allocation with hedge funds described in Fig.2, we assume that the fixed long-term economic environment remains within two fixed regimes: an extreme regime (with high financial market stress) and a normal regime (with low financial market stress). We then determine the allocation strategy in these two regimes.

In this study, we assume that 15% of the portfolio is invested in hedge funds. We then determine the allocation strategy with equity/bond substitutes and diversifiers with respect to economic regimes by minimising the standard deviation of the expected annual return subject to the constraints on the performance objective and parameters. In extreme market regime, investors should replace a part of their long-only equities with equity substitutes to improve more efficiently the risk/return profile of their portfolio. For the normal market regime, the allocation strategy with respect to the risk appetite parameter is presented in Fig.3.

In the normal market regime, it is possible to give priority to different families of hedge funds according to the target portfolio volatility.

• Low risk appetite: investors with target volatility below 6.5% prefer equity substitutes.
• Medium risk appetite: investors with target volatility between 6. 5% and 7. 5% invest in diversifiers.
• High risk appetite: investors with target volatility above 7.5% prefer bond substitutes.

Conclusion
Hedge funds are attractive investment tools, but are more sophisticated than traditional assets and therefore require more investment expertise. Hedge funds have become noticeably more mature in recent years, meaning that it is time to reassess hedge fund investments in SAA. The granularity of hedge funds allows us to evaluate and classify them according to their sensitivity to common risk factors. Hedge funds can be classified into equity/bond substitutes and diversifiers. Taking into account the non-normal distribution of hedge fund returns and economic periodicity, a regime switching Markowitz model is applied to examine portfolio allocation in an extreme market regime and a normal market regime. We show that investors should choose equity substitutes in an extreme market regime, while in a normal market regime, it is recommended for investors to use equity substitutes, diversifiers and bond substitutes if they are aiming for low, medium and high volatility respectively.

Notes

1. Hedge Fund Research database, 2013.
2. “The New Challenge for Hedge Funds: Operational Excellence”, Boston Consulting Group, 2013.