Allocating to Hedge Funds Should Be a Two-Step Process

May 02, 2012

The experience of two bear markets in the past decade reminded investors of the importance of diversification. This, coupled no doubt with some envy of the “endowment model” of the likes of Yale and Harvard universities, has caused many to increase their allocation to hedge funds. While this often makes sense, we think it’s important that investors set their expectations appropriately.

An investor making an allocation to passive equities unconditionally can expect to get the returns from equities (give or take some frictional tracking error). But an investor making an allocation to hedge funds should only do so on the basis that the manager has skill that will be rewarded versus cash.

This means that an investor thinking of diversifying into hedge funds should take the decision in two stages. The first decision should be whether to allocate money out of equities and into cash. The second is to move out of cash and into hedge funds.

Last year, the first decision would have paid off for investors who moved out of global equities, as Treasury bills (a cash equivalent) outperformed the MSCI World Index.  It would have been less successful for investors who moved out of US equities, because the S&P 500 rose 2.1%, beating cash.

The payoff to the second decision was even more problematic because the typical equity hedge fund was down by about 5.7%, as measured by the HFRI Fund of Funds Composite Index, the most commonly used broad measure for funds of funds and a good gauge of the overall industry.

Similarly, in 2008 an allocation out of equities and into cash would have been richly rewarded as global stock markets tumbled. But a decision to give the cash-benchmarked portfolio to a hedge fund manager would have typically destroyed value, as the HFRI Fund of Funds Composite Index fell 21.4%. Yet some investors claim to have been satisfied with their allocation to hedge funds in 2008 because “they outperformed the stock market”.

In my view this is naïve. These investors were using the wrong benchmark to gauge their level of satisfaction. Against cash, many hedge funds failed to produce the reward they aimed for.

Clearly, many hedge funds that were supposed to behave independently of the market had far more market exposure than one would have liked. In future, therefore, we expect savvy investors to frame the hedge fund decision as a two-step process. Step one is the appropriate definition of the benchmark, which will often be cash. Step two will be monitoring the value added, or not, versus that benchmark.

Thus, hedge funds that delivered a positive rate of return last year and that have managed to perform independently of market swings over time are most likely to gain assets in the years to come.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Allocating to Hedge Funds Should Be a Two-Step Process
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