Improving the Odds With Diversification
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Alpha strategies are intended to provide a differentiated return stream from stocks and bonds. In an ideal world, alpha strategies would earn higher returns when the 60/40 portfolio is struggling. As we’ve previously discussed, hedge fund managers in aggregate tend to be skilled at navigating market downturns. However, the data show that drawdown mitigation can take many forms. To visualize the diversification benefit of hedge funds strategies, we’ve taken every year since 2002 and tabulated the strategy class offering the maximum positive return differential to a 60/40 portfolio in that year.
The results depicted are aggregated gross of fee results which may not represent returns that any investor attained. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance not indicative of future results. Unlimited makes no guarantee that the source data utilized in the compilation was either accurate or complete.
As the data show, different strategies have offered the best return complement to a 60/40 portfolio at different times. Although emerging market strategies dominated the mid-2000’s, no single strategy has definitively offered the best path to diversification for 60/40 investors. And the recent data show that strategy diversification was critical to realizing a low-volatility return stream since 2020. Overall during the period since COVID, all the strategies delivered positive returns with no one strategy showing particularly outsized outcomes.
The results depicted are aggregated gross of fee results which may not represent returns that any investor attained. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance not indicative of future results. Unlimited makes no guarantee that the source data utilized in the compilation was either accurate or complete.
While all the underlying strategies did pretty well over the period, there were significant benefits of diversification as some strategies did considerably better than average in some years and considerably worse in others. That's the beauty of holding them all together through an index. The return consistency comes from the strategy diversification. Most recently, we’ve seen managed futures illustrating the benefits of diversification as the strategy delivered the greatest return differential in 2022, but then saw a reversal of fate in 2023.
The results depicted are aggregated gross of fee results which may not represent returns that any investor attained. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance not indicative of future results. Unlimited makes no guarantee that the source data utilized in the compilation was either accurate or complete.
And the story of return volatility looks pretty similar when you consider a separate dimension of hedge fund allocation: size. By tracking the difference between AUM-weighted hedge fund strategies and fund-weighted hedge fund strategies, we can proxy the performance difference between large and small hedge fund managers. The data show there is no obvious advantage to size. In this figure, a positive return differential indicates that large funds have outperformed smaller funds. While the data suggest there are short-term trends in performance, over the full sample the relative performance between the two groups roughly comes down to a coin-flip.
The results depicted are aggregated gross of fee results which may not represent returns that any investor attained. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance not indicative of future results. Unlimited makes no guarantee that the source data utilized in the compilation was either accurate or complete.
The moral of the story is pretty clear, while individual hedge fund strategies aren’t necessarily one-hit wonders, their outperformance is episodic. This appears to be true for two hedge fund attributes: style and size. To realize the diversification benefits of these alpha strategies, investors are well served by owning a broad basket of hedge fund strategy types. Diversification positions investors to capture a differentiated return stream that most reliably mitigates drawdowns and helps to compound capital for the long term.
For informational and educational purposes only and should not be construed as investment advice. The historical analysis discussed herein has been selected solely to provide information on the development of the research and investment process and style of Unlimited. The historical analysis should not be construed as an indicator of the future performance of any investment vehicle that Unlimited manages. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment. No Representation is being made that any investment will or is likely to achieve profits or losses similar to those shown herein.
