The arrival of investable hedge-fund indices has huge and welcome implications for portfolio construction. Asset allocators can now access genuine hedge-fund beta as well as a whole host of sub-classes – allowing them to build diverse and low-cost portfolios with precision.

Hedge funds are an attractive source of diversification in a multi-asset portfolio. As we noted in Keeping hedge funds on track, asset allocators have hitherto been unable to invest in this market passively. The only available benchmarks have been unreliable theoretical indices based on hedge-fund databases or “cash-plus” targets — neither of which are investable.

This has led to a situation in which hedge-fund allocations often go unfunded for months at a time as investors go through the arduous process of securing suitable active managers. As a result, many institutional investors have shied away from hedge funds altogether.

Without a reliable means of achieving the market return, these attractive strategies have been severely out of step with other asset classes. In recent years, exchange-traded funds and passive strategies for traditional assets have soared in popularity. But with no investable indices, hedge funds have been left behind. The new Hedge Fund Research (HFR) benchmarks change all that.

Less daunting, more accessible

The HFR indices are the first hedge-fund benchmarks that can be owned by investors. They offer returns dating back to 2005, allowing investors to compare performance and correlations with other asset classes through a variety of market environments.

This means that multi-asset investors don’t have to devote a disproportionate amount of time, money and energy to their hedge-fund allocation, which is typically a relatively small proportion of assets. Instead, they can simply accept a market return through an investment in the index while they decide on an active manager. Alternately, they can forego active management and its attendant risks altogether and rely on the index return for the long term. At a stroke, the entire hedge-fund universe has become less daunting and more accessible.

This is a welcome development for all multi-asset investors. As a portfolio allocation, hedge funds offer compelling attractions. They have relatively low correlations to the bond and equity markets, and, in aggregate, they have held up extremely well during market crises. The HFR 500 Index has outperformed the MSCI World Index by substantial margins during all of the major market sell-offs of the past 15 years.

Drilling down

Hedge funds constitute an attractive investment in their own right, not least because of their diversification benefits versus other asset classes. But the hedge-fund universe also offers considerable internal diversity. The HFR range of indices allows asset allocators to focus on specific components of this universe, enabling them to achieve precisely the exposures that work best in the context of their portfolios.

So, while the HFR 500 Index includes the 500 largest investable hedge funds, this broad index can be broken down into four main sub-indices based on strategy: macro, equity hedge, event-driven and relative value. Investors can now invest passively in just one of these or in any combination of the four.

Below the four main sub-indices are a further 26, such as equity market-neutral, credit arbitrage and volatility. This allows investors to drill down and select just the sub-indices that complement their existing asset allocations. In effect, they have a broad range of building blocks with which to create bespoke exposures.

By examining how each sub-index has performed during notable market events, investors can assess the diversification benefits of a whole range of potential portfolios with different hedge-fund allocations and select what is most efficient for their investment needs. By contrast, a cash-plus model is useless for this kind of modelling, as there’s no way that cash-plus returns could have actually been achieved over a given period.

In Keeping hedge funds on track, we noted that the traditional 60/40 equities/bonds portfolio is widely considered obsolete. The well-documented tendency of equity and bond returns to correlate positively means that such a portfolio is unlikely to provide sufficient diversification.

On top of this, we’re in a low-interest-rate environment. This means that fixed-income may no longer offer the level of yield and defensiveness that it did in the past. The need for genuine diversification is growing more urgent.

A 60/40 portfolio could be transformed through an allocation to hedge funds, which have a relatively low correlation to both equities and bonds. The question, then, is: What size should a hedge-fund allocation be?

A range of approaches

Institutional investors can now consider various ways of using passive hedge-fund exposures in their portfolios, in line with their overarching asset-allocation goals.

For example, they might take a “core/satellite” approach to their hedge-fund allocation, obtaining the bulk of their exposure through passive investments to reduce costs while seeking to access hedge-fund alpha through capacity-constrained high-conviction allocations to single managers.

An alternative would be to take exposure to one type of strategy without taking on fund-selection risk. So an allocation could be made exclusively to macro funds through the appropriate HFR index — perhaps on the grounds that those funds are likely, in aggregate, to perform well in the current interest-rate environment. And targeting beta — the market return — over alpha avoids the idiosyncratic risks inherent in macro strategies.

Meanwhile, investors can use passive hedge-fund allocations on a temporary basis during periods of transition in the portfolio. This means that clients’ money does not sit idle during these periods but is instead deployed in a way to earn the market return for the portfolio exposure.

Finally, investors who have previously avoided hedge-fund investments because of their complexity, cost, operational risk and headline exposure can take a lower-risk approach without any of the manager selection risks at a reasonable cost.

All in all, the HFR indices provide simple solutions to access genuine hedge fund exposure. They bring hedge funds in line with other asset classes and offer investors a whole new universe of passive diversification.  

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