Hedge funds typically advertise themselves as a good way to get absolute returns that are uncorrelated to stocks and bonds, but long/short strategies mopped up last year on the back of the stock market rally and were awarded with strong net inflows.

Instead of arguing about whether this is the rise of smart beta, or if some hedge funds have shirked their mandate to find returns that an index can’t provide, Lyxor Asset Management quants Zelia Cazalet and Ban Zheng have simply reclassified hedge funds into three distinct categories as a new starting point for portfolio management: equity substitute, bond substitutes, and diversifiers.

“Hedge funds are attractive investment tools. Nonetheless, they are more sophisticated than traditional assets, hence requiring greater investment expertise,” write Cazalet and Zheng. “Hedge funds are heterogeneous and cannot be considered as a single asset class, especially after the subprime crisis. Hence, it is no longer appropriate to follow the traditional approach which considers the whole hedge funds as a separate asset class.”

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Moving beyond strategy/style categories

Most people divide hedge funds by category, and it’s clear that a distressed fund shouldn’t really be directly compared to a long/short or macro fund when judging performance, but that still leaves the question of how investors should decide where to put their money.

The advantage of Cazalet and Zheng’s approach is that it more clearly specifies the role that hedge funds play in an investor’s portfolio. Equity substitutes should outperform other hedge fund categories when the market is bullish, as they did last year, but they should also protect investors from outsized losses in a downturn. Assuming a 15% allocation to hedge funds overall, with a pretty normal bond/equity split for the rest of the portfolio, Cazalet and Zheng think that the first step in choosing a strategy is to decide how much risk appetite you have and then choose the category that meets those goals.

Three categories of hedge funds correspond to risk appetite

They recommend that investors with a low appetite for risk will want to use equity substitutes to reduce the volatility of their equity position, and investors with a large appetite for risk should increase their overall equities position and then supplement bonds with bond substitute hedge funds.

The role that hedge funds are most often thought to play, providing diversification benefits, Cazalet and Zheng would only recommend to investors with a moderate appetite for risk (defined as seeking volatility between 6.5% and 7.5%).