Leave just one key ingredient out of a favorite recipe and the outcome is likely to be unsatisfying. We think it’s an apt analogy for investment portfolios in the current economic and market environment, which is raising three important questions among asset allocators we talk to:
In all three cases, we think the answer may include adding hedge funds into the asset allocation mix. In this article, we’ll look at how multi‑strategy hedge funds may enhance diversification and how equity long/short hedge funds may dampen volatility without sacrificing return.
For the better part of the past 20 years, allocators have generally been able to count on the negative correlation between stocks and bonds — when stocks have struggled, bonds have helped cushion the blow. During the global financial crisis (GFC), from November 2007 through February 2009 (peak to trough), US stocks lost 51% but 10‑year US government bonds gained 19%. And during the dot‑com bust between September 2000 and September 2002, stocks fell 45% while bonds rose 28%.
Beginning in 2022, however, this relationship became less reliable. That year, stocks and bonds sold off by ‑24% and ‑17%, respectively. And since then, the correlation has stayed in positive territory on a three‑year rolling basis (Figure 1). What changed? Inflation returned.
Looking ahead, we think inflation will be a part of the investment narrative for the next 5–10 years due to deglobalization and trade tensions, tight labor markets, underinvestment in commodities, and rising fiscal spending. While AI‑driven productivity gains could offset these pressures, we think increased deficit spending is inevitable and will drive inflation pressures.
Given this economic outlook, fixed income may play a less potent diversification role in portfolios. To prepare, we think allocators should broaden their investment toolkit to include additional sources of return that may be uncorrelated to traditional assets.
Multi‑strategy funds generally maintain exposure across hedge fund strategies such as macro, long/short equity, and long/short credit strategies, in pursuit of a more stable risk and return profile. By combining strategies and tightly managing aggregate risk, multi‑strategy funds create the potential to provide considerable portfolio‑level diversification.
In periods of market stress over the past 35 years when stocks experienced peak‑to‑trough declines of more than 10%, multi‑strategy hedge funds outperformed stocks in each case. While they didn’t deliver a positive return in every sell‑off, they helped cushion the blow when bonds failed to diversify — especially in inflation‑driven environments such as 2022.
To illustrate one possible approach, Figure 3 starts with a 60/40 portfolio and shows the effect of replacing fixed income in five‑percentage‑point increments with a composite of equal‑weighted multi‑strategy hedge funds. Portfolio returns rose meaningfully while volatility increased only marginally.
Since 2020, both macro and market volatility have risen meaningfully. Inflation has forced central banks into a difficult balancing act, resulting in more policy uncertainty across regions. Elevated government debt burdens, geopolitical tensions, and high equity valuations further contribute to volatility.
In this environment, one way asset owners may be able to make their portfolios more resilient is by replacing some equity exposure with equity long/short hedge funds.
By design, equity long/short hedge funds have much less equity market exposure than long‑only equities. The HFRI Equity Hedge Index, for example, has a long‑term equity beta of 0.46. Long/short funds can also dynamically reduce net exposure during sell‑offs.
During periods of extreme volatility, long/short equity hedge funds have typically delivered less severe drawdowns than long‑only equities. Replacing portions of long‑only equity exposure with long/short strategies has historically resulted in modestly higher returns and meaningfully lower volatility at the portfolio level.
Strong gains in US mega‑cap technology stocks have left equity valuations elevated and index concentration extreme. Wellington’s 10‑year capital market assumption (CMA) for hedge funds (5.0%) is well above its CMA for large‑cap US stocks (3.4%).
While hedge fund performance was uneven between 2010 and 2020, we think today’s environment of higher macro volatility and interest rates may be more fertile. Governance and fee structures across the industry have also improved.
Allocators are grappling with higher stock/bond correlations, greater volatility, and concentrated equity exposure at high valuations. Replacing some fixed income exposure with multi‑strategy hedge funds and some equity exposure with long/short strategies may help improve portfolio resilience.
The implementation and results of these ideas will ultimately depend on manager selection, with a focus on the role a fund plays in a portfolio, the manager’s demonstrated skill, and a clear approach to risk management.
Sponsored by Wellington Management
Wellington Management for US Wealth Founded in 1928, Wellington Management is one of the world’s largest independent investment management firms. For nearly a century, we have partnered with leading global institutions to strengthen portfolios, navigate change, and deliver enduring results. Today, we bring the same institutional rigor, perspective, and discipline to our relationships with financial advisors.
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