‘The case for Hedge Funds: Can Alternatives offer downside protection in a portfolio of Equities? ’

Hedge Funds can mitigate the effects of large shifts in the market using short positions and derivative instruments. One would expect that a US-focussed long-short equity manager would provide an effective hedge against the S&P 500 Index or that a CTA manager can effectively protect against shifts in global commodity prices.

But, can adding hedge funds to a traditional equity portfolio improve performance and reduce risk?

We have taken the ‘top’ 5 actively reporting CTA, Long-Short Equity, and Fixed Income hedge funds determined by AlternativeSoft’s ranking algorithm for asset selection.

Attributes that were deemed desirable were:

- A track record of over 80 months.
- USD reporting currency.
- Highest Annual Sharpe Ratio since inception

*Data Provided by Eurekahedge. *

Table 1 shows annualised returns, volatility, and Sharpe statistics for the funds we have identified; the assets from our search fit the criteria of having high risk-adjusted returns.

This table also shows the calculated “% of Time in Drawdown” value for each fund which describes how much time the fund has historically been in a drawdown state.

Using the same methodology, the historical probability that the indices cumulative returns are in a drawdown state has been found for the S&P 500 and S&P Goldman Sachs Commodities Index (GSCI).

The results, presented in figure 1, show that 78% of the time the equity index is in a drawdown state and 95% of the time the commodities index is in a drawdown state since January 1970.

We have also calculated the average % of time in drawdown across each of the strategies outlined in Table 1 since inception.

Figure 2 indicates that for all three strategies the probability of an investor staying ahead, on average, is considerably higher than an investor who tracks the market.

Will adding a 20% allocation to alternatives improve a portfolio if U.S. mid-large cap equities if we select these alternative funds based on historical drawdowns?

We have constructed a small portfolio of 30 blue-chip U.S. mid-large cap equities with equal weightings; the historical cumulative returns can be seen in figure 3.

The bottom 20% of assets, determined by historical probability of drawdown, were removed and replaced with 6 of our hedge funds (Table 1) which include a blend of strategies. The funds selected were FI Fund 1, FI Fund 2, CTA Fund 1, CTA Fund 2, LSE Fund 3 and LSE Fund 2, these funds were all selected for their low % of time in a drawdown.

As seen in Figure 3, we have reduced the frequency and intensity of drawdowns which in turn increases our cumulative returns for Portfolio 2. Table 2 shows the comparative statistics for our portfolio before and after the introduction of these hedge funds. As expected, adding low drawdown hedge funds to the portfolio had a significant impact on the portfolio time underwater.

Table 2 above reinforces the point that we have increased return and decreased risk with a 20% allocation to Hedge Funds.

Obviously, we rebalance this portfolio periodically (based on % time in a drawdown state) and we would end up with a larger allocation to FI Fund 1 as it drastically outperforms the other assets on a risk-adjusted basis.

One final caveat to bear in mind; although this article states that selecting hedge funds using the above metrics can be effective, due to the nature of hedge fund returns we only have a small amount of data points which means it is difficult to test this theory out-of-sample in an accurate manner. However it does serve to reinforce the view that allocation to the right Hedge Funds can offer diversification and downside protection in a portfolio.