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With interest rates on the rise at the fastest pace in years, allocators are understandably wondering whether fixed income can still perform certain roles in multi-asset portfolios, including return consistency and downside protection (Figure 1). In some cases, this is driving interest in hedge funds as a partial substitute for traditional fixed income allocations. The unconstrained nature of hedge funds can potentially make them a valuable building block for outcome-oriented solutions such as a fixed income substitute portfolio designed for different interest-rate environments.
A common approach has been to build a multi-manager hedge fund portfolio with bond-like volatility and minimal correlation to equities. Allocators constructing such a portfolio often focus on how to weight various categories of hedge fund strategies (e.g., Macro and Relative Value) 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.
Instead, we believe a style-factor lens can help allocators build portfolios of hedge funds that are more connected to the desired roles of fixed income. Here, we share some of our recent research on the behavior of our fundamental factors in different rate environments. We then explain how those insights might be applied to the process of selecting hedge funds for a multi-manager portfolio.
As members of Wellington’s Fundamental Factor Team, we use a “role-based” framework to help us understand portfolio managers’ alpha profiles. Using this framework, we evaluated which factors best filled the roles of a traditional fixed income allocation in historical periods of large moves in interest rates (up or down).1 Among the notable observations:
Having identified the factors that can potentially fill fixed income roles in specific rate environments, we analyzed the four main hedge fund strategy groups — Equity Hedge, Macro, Relative Value, Event Driven — to identify common factor profiles of funds within each group. Our high-level conclusion was that three of the four hedge fund strategy groups had relatively similar behavioral profiles, albeit with large differences in the proportion of managers with significant factor tilts. Specifically, a meaningful number of managers across Equity Hedge, Relative Value, and Event Driven strategies had long exposure to Risk Seeking factors and/or Mean Reversion factors, with some having short exposure to Risk Aversion factors as well.
We think this emphasizes the need to not be overly reliant on top-down strategy group allocations when assembling a portfolio of hedge funds. Instead, we see a case for focusing first on mapping the roles of individual hedge funds to key portfolio objectives. We think this can help mitigate the risk of having a portfolio that appears well diversified on the surface but fails to deliver a consistent profile across different market environments.
In our recent paper, “Can hedge funds behave if fixed income doesn’t? A manager-selection view”, we provide a detailed case study of how this can work in practice, including profiles of hypothetical portfolios of hedge funds designed for different interest-rate environments (Figure 2) — an illustration of the potential benefits of using a role- and behavior-based approach to increase alignment between manager research, the investment process, and portfolio objectives.
1Largest 5% of weekly moves in 10-year US Treasury nominal yield over 10 years ended 31 December 2021. Sources: Wellington, HFRI, FactSet, Bloomberg. Additional information on this data is available upon request. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE.
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