Pension funds are showing an increasing interest in investing in hedge funds as an asset class in its own right. But how sensible is it to consider hedge funds as a single asset class?
Hedge fund indices tend to lump together the various investment strategies into a single universe of some 6,000 to 7,000 hedge funds. Yet this may ignore the fact that there is a fault line running through this universe and that hedge funds are not one but two asset classes.
Patrick Fenal, chief executive officer of Unigestion in Geneva, which manages hedge funds for leading Swiss pension funds, believes that treating hedge funds as a single asset class is mixing apples with pears. “We don’t really believe that hedge funds are one asset class. We believe that in terms of conditional correlation versus equities it is two asset classes. If you consider them simply as one universe they appear to behave strangely. So the first task is to separate them into two blocs.”
One bloc is equity-related and represents around 60% of the total universe. It is composed of hedge fund strategies that show some correlation with the equity market. The long-short equity strategy clearly belongs in this bloc, but so, too, do distressed securities and event driven strategies. Both strategies have medium and positive exposure to equity returns.
The other bloc includes a mix of strategies that have little or nothing in common with each other. These are the defensive strategies, where hedge fund managers aim to avoid any correlation with either equities or fixed income. This will include hedge fund strategies such global macro, CTAs (commodity trading advisors) and certain arbitrage sub-strategies (convertible, statistical and optional, forex and commodities).
Dividing the hedge fund universe in this way helps to make sense of the performance of hedge funds during the worst equity bear market for 30 years, says Fenal. “If you look at the total universe of hedge funds you will see that it was not performing so well in the last three years and you may wonder why. However, if you separate the universe into the two blocs you can see that in the last three years the equity-related bloc performed fairly poorly – not particularly badly but basically the average would be less than 0% return over the past three years. However if you look at the defensive bloc you will see that it made money over this period.”
The market has not yet fully grasped this distinction, says Fenal. Pension funds that approach Unigestion to manage their hedge fund exposure are often surprised to be asked which particular hedge fund universe they wish to invest in. “When you ask pension funds what they want, they will say they want everything. But we tell them that you cannot judge these two sub-universes the same way because they will have different objectives.”
The objective of the defensive universe is to generate absolute returns, in the sense of performance which is uncorrelated to either the equity and bond markets. However, the equity-related universe is not expected to produce absolute returns in an equity bear market. Instead, it will move broadly in line with the index, although it will be expected to participate more on the upside than on the downside.
Pension funds with little experience of hedge funds will tend to choose the defensive strategy, says Fenal. Currently 90% of the assets under management at Unigestion are in the defensive universe, chiefly because of higher demand for this strategy by institutional clients.
Yet Fenal believes that pension funds would be better served if they followed the equity hedge strategy by replacing a portion of their long-only equity portfolio with plain vanilla equity long/short. By moving into highly active equity management at one end of the scale, they can get 75% of the upside but only 25% of the downside.

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