What is commonly called the hedge fund universe contains not one, but several, asset classes . Without listing them exhaustively, these main strategies are :
q Arbitrage
q Currency
q Distressed
q Event-driven
q Global macro
q Short selling
q Systems
q Equity Hedge.
Each of these can be broken down into numerous sub asset classes. If we were to describe all the strategies related to hedge funds precisely, we would be left with a multitude of them. For the equity hedge strategy alone, the universe can be broken down in the following ways:
q Geographically: worldwide, US, Europe, Asia, Japan, emerging markets;
q Style: growth, index, value;
q Company size: small, medium, large capitalisation;
q By sector: healthcare, technology, telecommunications etc.
In a correlation universe, the multitude of strategies can be broken into at least two main categories :
q A category showing a decorrelation with stocks and bonds: real hedge funds
q A category showing positive correlation with stocks: equity hedge funds.
Real hedge funds
Let us start with a typical European institutional portfolio with an investment breakdown of 37% cash, 41% European bonds, 5% international bonds, 12% European stock and 5% US stock.
Before constructing a hedge fund portfolio, it is necessary to fix the clients’ objectives and constraints. For example, their objectives might be:
q Low correlation with the global portfolio: maximum 0.20;
q Limited drawdown when the global portfolio is down;
q Fixed income volatility: between 4–8%
The constraints might include:
q Average liquidity of the ‘real hedge funds’ portfolio: maximum one year;
q Limits per strategy: maximum 50% in global macro and 20% per strategy;
q Historical performance objective: 10–15% EUR ? per year.
Taking into account these criteria, an optimisation is carried out on our universe of hedge fund products.
The result by strategy is broken down into:
Number of
managers
in each strategy
Global macro 30% 3
Arbitrage 20% 2
Currency 20% 2
Systems 15% 3
Short seller 10% 2
The statistics of this portfolio are:
q Correlation with global portfolio (three years): 0.18
q Correlation with MSCI Europe 15: –0.01
q Historical volatility (three years): 5.22%
q Historical performance (annualised performance over three years): 16%.
To test this hedge funds portfolio in an unfavourable environment, we have compared the bearish periods of the global portfolio with the real hedge funds portfolio (Figure 2).
As we can see, such a portfolio shows a majority of positive months when the global portfolio is negative. Figure 3 traces the performance evolution of the global portfolio and of the global portfolio with 10% of hedge funds included. Their inclusion would have increased the total return, and decreased the global volatility by about 7%.
Historically, as has been demonstrated several times in the academic literature, the contribution of hedge funds has been favourable in terms of risk- adjusted return.
Equity hedge funds
This category includes strategies correlated positively with stock indices.
We study the substitution of the US equity allocation (5%) of the same global portfolio by a US equity hedge funds portfolio with five managers.
First, we look at the behaviour of the equity hedge funds portfolio when the S&P 500 is negative (Figure 4). As we can see, the hedge fund portfolio offered distinctly less negative returns than the S&P 500, and even some positive returns. Figure 5 traces the performance evolution of the global portfolio with and without the US equity hedge fund. The percentage invested is 5% and it replaces the US equity allocation. If the impact on the performance is not significant, there will be a reduction of 7% in terms of the volatility.
These results would seem poor if we did not bear in mind that most of these managers had an average market direction of 50%, if we take into consideration their long and short positions!
Finally, we have introduced both real hedge funds and equity hedge funds into the global portfolio.
Figure 6 shows the statistical results and the performance evolution between this portfolio and the global portfolio. We can note that there has been a significant improvement in the performance, with a significant reduction in the volatility of about 13%.
Introducing hedge funds therefore brings significant gains to a diversified institutional portfolio in terms of volatility reduction and performance improvement. Our investment process focuses on a ‘top-down’ approach for the investment strategy forecast and at the same time a ‘bottom-up’ approach for the individual selection of managers.
Patrick Fenal is chief executive and Isabelle Borello is a senior manager at Unigestion Asset Management in Geneva

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