There has been a lot of innovation in asset allocation and portfolio construction over the years, including efforts to enhance diversification without sacrificing returns. Fixed income portfolios have been a particular area of focus, with market headwinds and allocators’ shifting objectives driving interest in the use of hedge funds as a partial substitute for traditional fixed income allocations. 

A common solution has been to build a multi-manager hedge fund portfolio with bond-like volatility and minimal correlation to equities. But we see pitfalls in this approach. For example, volatility and correlation levels are often conditional on the market regime, and therefore unstable and unreliable when targeting a specific outcome. In addition, allocators constructing such a portfolio often focus on how to weight various categories of hedge fund strategies (e.g., Macro and Relative Value) in order to navigate certain market environments. But we have found that the behavioral profiles of hedge fund categories have been more similar than not in recent years, suggesting that a portfolio structured in this way may be less diversified than it appears. 

In this paper, we propose an alternative approach for analyzing hedge funds and constructing multi-manager hedge fund portfolios intended to stand in for fixed income. As factor-based manager researchers and allocators, we believe a style-factor lens can help allocators understand the biases of their managers and define the desired roles of their investments. Here we use that lens to help capture the roles of a fixed income allocation and build portfolios of hedge funds that are more connected to those roles and the desired outcome. Among our key conclusions: 

• A role-based framework can help better align manager research, portfolio construction, and potential investment outcomes. 
• Decisions about allocations to individual hedge funds can have a greater impact on the role and behavioral profile of a multi-manager portfolio than decisions about how to weight different hedge fund categories. 
• As a result of the unconstrained nature of hedge funds and the tool kit at their disposal, they can potentially be used to build targeted outcome-oriented solutions such as a fixed income substitute portfolio designed for different interest-rate environments.

What is fixed income’s role — and can it get the job done?

In CIO offices around the world, allocators are asking questions about whether fixed income can continue to reliably fill certain roles, including those commonly played by interest-rate and credit spread allocations, in different market environments. At the risk of a very US-centric reference, it brings to mind the words of Bill Belichick, a well-known coach in American football, who famously reminds his players that success relies on their willingness to play their role — or as he puts it, “Do your job!” This is our mindset when managing client solutions. We start by asking what role the allocation is intended to fill. 

To bring this to life, Figure 1 distills the many use cases for fixed income into four high-level roles and highlights the corresponding segments of the fixed income market that have historically been used to fulfill them. For example, “return consistency” is naturally aligned with a yield-focused mix of assets that may offer stable and consistent spread or carry-oriented pickup while “downside protection” requires countercyclical exposure most sought after when risk assets, such as equities, are out of favor.

Figure 1

While we think fixed income continues to warrant a seat at the asset allocation table, the search for complementary or even substitute allocations is warranted given that investors have been confronting some of the most challenging bond market conditions in their careers. Although the global market picture has changed significantly since the beginning of 2022, there was evidence at that point of record-high exposure to interest-rate sensitivity paired with record-low outright yields (Figure 2).

This market setup created arguably limited prospects for future diversification and downside protection potential in both rising and declining interest-rate environments, leaving many scratching their heads when trying to effectively source these two very important portfolio roles. Looking at traditional high-quality global bond benchmarks, the steady and incremental increase in duration extension has been quietly exposing allocators to some of the highest interest-rate sensitivity in recent history. 

Turning more specifically to the US market, the combination of record-high duration, record-low yield cushion, and elevated interest-rate volatility has brought about a more muted downside protection profile for US Treasuries during periods of equity market weakness. Using our market environments model, Figure 3 shows that over the last 10 years (dark blue bars), US Treasuries returned 0.21% during weeks when the S&P 500 Index had a negative return (Equity Lagging). And in the most extreme negative environments for equities (Equity Left-Tail), Treasuries returned an even stronger 0.33% on average. Over the last two years, however, there has been a striking decline in downside protection from US Treasuries in both of the equity environments, for the reasons articulated above. It is worth noting that equities returned -3.32% and -3.76% in the Equity Left-Tail full period and the last two years, respectively

Where do hedge funds fit in?

We are by no means suggesting that bond allocations go to zero in portfolios. Our view is simply that there can be times when an allocator seeks to offset specific types of exposures within a multi-asset portfolio and that a role-based mindset can help bring structure to the process. 

If hedge funds are the portfolio tool of choice, then we need to also assess the roles and behaviors of a hedge fund’s components, and here we believe views are evolving. For example, we think many allocators no longer expect a portfolio of hedge funds that has broad exposure to all of the main strategy groups to realistically generate…

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