Besides being an asset class in their own right, hedge funds can also be considered and used as a diversification tool within a specific traditional asset class.
To incorporate hedge funds as a separate asset class into a global diversified portfolio, it is recommended to select the appropriate number of strategies and fund managers in order to obtain an optimal risk/return profile. This strategy can be achieved by using funds of hedge funds: SG AM Alternative Diversified Fund gives exposure to hedge funds with a low volatility and a diversification into the largest number of strategies and managers.
In the present article, we illustrate how specific hedge fund portfolios can be used to improve the risk/return profile of a single asset class portfolio. We look at a global government bond portfolio being managed in a passive way, ie, without the active management of the duration or the foreign exposure components.
After extensive research, we found that relative value strategy offers an optimal diversification to a global government bond portfolio. Relative value hedge funds include a number of sub strategies linked to high yield bonds and credit. Consequently, they offer an indirect exposure to equity markets. The correlation between HFR Relative Value Index (used as a proxy in our study) stands at 0.54 with SSB High Yield Index and at 0.47 with S&P 500 over the last six years. We also show that, over the medium term in various market environments, a portfolio comprised of approximately 50% bonds and 50% relative value hedge funds is superior in terms of Sharpe ratio to any other combination of bonds and global hedge funds, high yield bonds or equities.
This study is carried out according to different market conditions based on the two following indicators: the interest rate level measured by the US Generic Government Bond 10-Year Yield Index and the risk aversion level measured by the VIX Index. This index is followed by equity and balanced portfolio managers. In general, over the medium term, it is also a good indication of the level of risk aversion among fixed income investors.
Firstly, we highlight the respective performances of a bond portfolio and the relative value strategy in an adverse situation for a bond investor: a rise in the US Generic Government Bond 10-Year Yield Index (Figure 1).
The bond investor sees the performance of his portfolio decreasing when the interest rates rise. However, in this scenario, the performance of the relative value strategy is positive and thus offsets the loss resulting from the rise in interest rates. Consequently, the relative value strategy represents a good diversification tool within a bond portfolio. In order to measure the overall impact of the diversification of a bond portfolio thanks to the relative value strategy, we look at the behaviour of a composite portfolio, 50% bonds and 50% relative value strategy (blue line). The performance of the total portfolio is above 45bps per month, whatever the level of interest rates. When the 10-year yield remains below 5%, the performance does not worsen. Above 5%, the performance of the relative value strategy enables the manager to increase the portfolio’s overall performance.
The previous analysis showed the relevance of investing in the relative value strategy in order to hedge the risk of a rise in interest rates. It is essential to assess the cost of this hedging if other adverse scenarios occur. This is why we study the performance of the bond and the relative value strategy components of the composite portfolio when the market risk-aversion increases, as represented by an increase in the VIX Index (figure 2).
During stressed situations, corresponding to sharp drops in the equity markets, turning into high values of the VIX, the relative value strategy performs less well because it is adversely affected by the portion of high yield sub-strategies. Nonetheless, this limited under-performance is widely offset by the increase in the performance of the bond component, since a stress situation generates a flight to quality, which in turn translates into a fall in interest rates. The performance of the composite portfolio, 50% bonds and 50% relative value strategy (blue line) remains flat, around 75bps per month, that is to say, approximately 9% per annum. The efficient frontier chart validates the strategy of introducing relative value hedge funds into a bond portfolio since they already include an exposure to equity and high yield bonds, albeit indirectly (Figure 3).
As illustrated above, the optimal level of relative value is around 50%. In order to further analyse the optimality of this composite portfolio, we compare it to three other diversified portfolios: 50% JP Morgan Global Government Bond + 50% HFR Fund of Funds, 75% JP Morgan Global Government Bond + 25% S&P 500 and 75% JP Morgan Global Government Bond + 25% SSB High Yield, which have similar levels of volatility (Figure 4).
Statistical indicators in the table below illustrate the behaviour of different types of diversification during the period from May 1997 to April 2003.
Whether we retain the criteria of pure return measured by the annualised performance, the performance stability measured by the annualised volatility and the maximum drawdown, or the return adjusted by volatility measured by the Sharpe ratio, the result is that a fund of funds of relative value strategy is better adapted to diversify a bond portfolio.