EUROPE - Using hedge funds can halve the probability of extreme loss in a portfolio, according to a new study from Edhec Risk and Asset Management Research Centre.

Rather than consider hedge funds as a separate asset class, the study – The Benefits of Hedge Funds in Asset Liability Management -- says they should be treated as a complementary management style to asset classes such as equities and bonds.

“In the past, hedge funds have been considered to give alpha benefits for asset managers,” says Peter O’Kelly, marketing manager, Edhec Risk and Asset Management Research Centre. “But their main benefit is to reduce risk by diversification, particularly since they are not correlated with other asset classes. So rather than look for absolute returns from hedge funds, managers should be thinking in terms of using them to diversify the portfolio and reduce volatility.”

The study’s authors, Lionel Martellini and Volker Ziemann, say: “It is possible to construct diversification benchmarks that allow the risk related to holding stock or bond portfolios to be reduced in a very significant and robust way, by a) appropriately selecting the alternative strategies and b) optimising these with proven techniques.”

The report continues: “These diversification benchmarks thereby allow the long-term volatility parameters of the stock and bond classes to be reduced significantly. As a result, introducing these diversification benchmarks as complements to the traditional classes enables ALM performance to be improved significantly.”

Martellini and Ziemann say that their pragmatic approach shows that an allocation of 20% to hedge funds means the probability of extreme loss of a pension fund can be reduced by 50%. And they say that introducing hedge funds as 10% of the overall allocation can lead to a 25%-plus reduction in the probability of the asset values falling below 75% of the value of the liabilities.

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