Hedge funds were overshadowed by equities in 2013, but now that there is a dearth of cheap stocks and fixed income still looks unattractive, it may be time to take a second look at including hedge funds in your portfolio.

Citi: The easy money is over

“We continue to see our clients under-exposed to hedge funds relative to our 16% recommended allocation,” writes Citi’s global head of hedge fund research Eric Siegel. “The current low-yield environment, with equity market rallies over the past few years, argues strongly for adding a source of uncorrelated returns to a diversified portfolio. Simply put, the easy money in the traditional markets is likely over.”

Hedge funds aren’t expected to keep up with equities during a bull market, but a good hedge fund manager can generate alpha over an entire investment cycle, and the risks usually have low correlations with market beta. When the implied correlation between stocks doubled during the financial crisis this broke down to some extent, but now that implied correlation is back to normal levels hedge fund managers are seeing their alpha increase.

spx avg implied correlation

Manager selection is essential for investing in hedge funds

It’s not enough for an investor to decide to put money into hedge funds; each fund has a unique strategy with unique risks that need to be evaluated.

“Regardless of strategy, we would like to stress the importance of manager selection. Simply investing in hedge funds as an asset class is not enough,” writes Siegel. “We tend to prefer those managers that have an identifiable investment edge, often related to expertise in specific industry sectors.”

He also says that managers who offer less liquid terms tend to have better returns. Hedge funds usually have terms ranging from quarterly to annually, but the longer time frames give managers more freedom to make use of longer-term strategies like distressed debt when they are more attractive than liquid assets. Again, this might not matter as much during a bull market when equities outperforms everything else, but over an investment cycle different asset classes (Without different amounts of liquidity) will offer the best risk/reward, and if you’ve found a smart fund manager you want to give him room to maneuver as market conditions change.

correlation liquidity and hedge fund returns