Can certain hedge fund strategies enhance the 60/40 portfolio?

Combining equities with bonds in a 60/40 split has been a popular investment strategy for decades because their returns have been negatively correlated with each other.

When stocks performed poorly, bonds did well and vice versa (on average). Their offsetting returns have enabled investors to build less volatile portfolios, manage market drawdowns and improve performance.

However, the extraordinary monetary and fiscal policy response to the Covid-19 crisis has tightened the relationship between equities and bonds.

For example, the six-month correlation between US equities and Treasuries recently turned positive, making portfolio diversification harder to achieve than before.

At the same time, equity valuations look increasingly expensive and bond yields are at all-time lows, suggesting more challenging times may lie ahead for each.

This backdrop is undermining confidence in the viability of the 60/40 model. Yet investors are still seeking to generate capital growth while protecting their portfolio from market falls.

Certain types of hedge funds could well help with this because of their alpha potential, relatively low volatility and minimal correlation to mainstream markets.

We analyse two alternative strategies that are worth investors considering: equity market neutral (EMN) and multi-strategy (MS) hedge funds.

Comparable returns with less risk

EMN strategies aim to offer positive returns regardless of whether equity markets are rising or falling.

They achieve this by having low net exposure to the market and focusing on the idiosyncratic returns of long and short positions within a portfolio.

Since this strategy tends to generate steady performance over time, it can potentially substitute the bond portion of the 60/40 portfolio.

For example, over the past 20 years, EMN hedge funds have generated similar returns to US Treasuries, but with around half the volatility and a correlation of just 0.3 to global equity markets (see table below).

Meanwhile, MS hedge funds add a further layer of diversification by investing in multiple HF strategies. But, unlike EMN strategies, they may take some directional market risk.

This generally results in equity-like returns with bond-like risk. Although MS hedge funds exhibit a varying degree of correlation to equity markets, they tend to have a lower beta compared to more directional hedge funds.

For this reason, some investors may view this approach as either an “equity” or “bond substitute”.

Nevertheless, both EMN and MF strategies have historically delivered higher risk-adjusted returns than equities or bonds alone, regardless of whether risk is defined as the standard deviation of total returns or standard deviation of below-average returns. 

Downside protection during market drawdowns

Another consequence of these hedge fund strategies’ relatively low risk profile is the potential to limit major losses during market corrections.

For example, since the year 2000, both EMN and MS hedge funds outperformed equities during their worst drawdown periods, although somewhat less than US Treasuries.

What impact would a hedge fund allocation have on your portfolio? 

EMN and MS strategies may complement an investor’s bond and equity allocations by improving their risk and return experience.

To illustrate, let’s suppose your portfolio has a 60/30/10 split, in which the 60% allocation is to global equities, 30% is to US Treasuries and 10% is to an EMN hedge fund index.

Is this portfolio more or less volatile than the traditional 60/40 equity/bond allocation? Well, it depends on how correlated equities and bonds are.

In a scenario where bonds and equities have a correlation of 0 or more, a 10% EMN allocation can reduce portfolio volatility (dark blue line in the chart below).

In fact, the impact is even more pronounced if we swap out 10% of the equity exposure for 10% in a MS hedge fund index, such that the portfolio has a 50/40/10 split (light blue line).

To be fair, given the high volatility of global equities, a similar risk reduction can be achieved using an EMN allocation.

However, it would fail to deliver a comparable absolute return to equities (recall that MS hedge funds tend to offer equity-like returns with bond-like risk).

This means that, regardless of our correlation assumption, a MS allocation has the potential to reduce portfolio volatility without sacrificing return potential.

One key consequence of this feature is that risk-adjusted returns will tend to be significantly higher for portfolios with a MS allocation.

Portfolio efficiency can also be improved with an EMN strategy, although equity/bond correlations would need to be greater than 0 to justify the allocation. This is shown in the chart below.

Data limitations

One of the frequent criticisms of hedge funds is that fund managers report returns voluntarily to data providers and so are likely to do so only when their performance has been good.

This introduces a self-selection and backfill bias as indices will include past realised returns.

What’s more, fund managers may stop reporting when their returns are extremely poor and fund closure is expected. All of these factors can inflate index performance and understate volatility. 

It is difficult to estimate the exact magnitude of these biases because they will vary across HF strategy and database provider.

However, this does not undermine the overall analysis nor its the implications. 

For example, the historical volatility for EMN and MS HFs would need to be at least 165% and 210% higher respectively to yield the same Sharpe ratio as a 60/40 portfolio.

Or alternatively, returns would need to be at least 40% and 54% lower, respectively
 
So there appears to be a good margin of safety here to adjust for some of these potential biases.

Time to rethink the classic 60/40 

While equities and bonds have been inversely correlated in the past, there is no guarantee this will continue in the future.

If you are worried about this risk, EMN and MS strategies can offer valuable portfolio diversification by limiting downside risk, dampening volatility and providing an additional source of returns.

A blended strategy could offer a compelling alternative to the 60/40 equity/bond portfolio, as it would incorporate the benefits of both EMN and MS investments into one vehicle.

What’s more, the above analysis focused on the performance of the average hedge fund, yet the true range of outcomes is much wider and the opportunity for top quartile manager selection is significant.