As investors look to strengthen portfolio performance amid a shifting economic landscape, a new Barclays study suggests hedge funds now offer “a compelling alternative” to fixed income allocations, and may prove key to bumping up returns as allocators adapt to a “shifting paradigm”.
Barclays’ report – titled ‘The Alternatives’ Alternatives: Hedge Funds as Alternatives to Long-Only Fixed Income’ – analysed more than 2,000 hedge funds. It explored the role played by hedge funds within broader investment portfolios during a number of market environments.
The study found investor sentiment towards long-only fixed income products is growing “significantly negative”, adding that hedge funds offer “a compelling alternative”, outperforming fixed income indices over a range of drawdown and remainder markets since 2015.
Among other things, Barclays’ Strategic Consulting team probed hedge funds’ behaviour across different market environments and the degree of performance diversification they offer.
The study said fears over rising inflation, coupled with fixed income’s recent lower yields, is fuelling growing skepticism over the prevailing 60/40 equities/bonds portfolio mix – traditionally seen as a “bastion of stability, providing consistent if unspectacular returns” across various market cycles.
“Over the past year or so, we’ve noted investors are increasingly looking to reduce their allocations to long-only fixed income as well as a steady uptick in investor interest around hedge funds that can serve as a replacement to the bond portion of the 60/40 portfolio,” Barclays said.
The research sliced hedge funds into three separate buckets, according to their correlation with the MSCI World and HY Global. These were: Equity/Credit Substitutes, Diversifiers, and Defensives – with the study focusing mainly on the latter two categories.
Barclays found diversifiers and defensives tended to outperform fixed income indices on a relative basis when compared to correlation and beta.
Specifically, since 2015, roughly 60 per cent of diversifier hedge funds have performed favourably against relevant indices during the main drawdown and remainder market environments.
“The best performing diversifiers perform well both during drawdowns, as well as during the remainder periods, suggesting investors do not need to choose between protection and upside capture,” Barclays said. “In addition, there is strong Sharpe persistence of top performing diversifiers, allowing investors to invest with high conviction names.”
However, it also noted equity and credit hedge funds within the diversifiers group saw increased correlation to the broader strategy balance during Covid-driven market rupture of March 2020, and warned investors should be “vigilant” when allocating to equity or credit-based diversifiers.
Similarly, roughly 65 per cent of ‘defensive’ hedge fund strategies outflanked their relevant indices during the period studied.
Barclays said the highest-performing defensive hedge funds based on drawdown performance demonstrated “very high persistence” from drawdown to drawdown, but gave up “significant upside capture”, leading to muted total returns. On the flipside, the highest performing defensive strategies during remainder periods also showed high persistence from one non-drawdown period to the next, while retaining strong downside protection.
“Unless investors are looking for tail risk funds, they are better served picking defensive hedge funds based on non-drawdown performance,” Barclays said, adding this will provide strong downside protection without the unwanted trade-off of upside capture.
