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Lyxor white paper looks at use of hedge funds in strategic asset allocation

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Lyxor Asset Management has published a new white paper looking at the use of hedge funds in strategic asset allocation.

In recent years, the hedge fund industry grew faster than non-alternative investments and assets under management surpassed 2007 levels at the end of 2013.
The interest of investors in hedge funds is historically driven by their appealing homogeneous performance before 2008, then considered as a single asset class. However, some strong divergences between strategies have appeared since (+/- 15 per cent), as they become more mature and granular.
A new paradigm appears and investors should now look at the relationship of hedge funds with traditional assets to better invest into them. Lyxor has introduced a new model to optimize alpha return from hedge fund investing in the strategic asset allocation framework.
The hedge fund industry has recently shown new characteristics. Hedge funds are becoming more mature and exhibit more significant performance divergence. While hedge funds’ performances were quite similar in terms of risk/return profile before 2008, more significant differences appeared during and after the crisis. For example, in 2008, the global macro strategy delivered a promising positive performance whereas other main strategies suffered significant losses. It seems that the tendency of strategic asset allocation (SAA) with hedge funds is characterized by their migration from a stand-alone asset to the equity and bond portions.
With this new paradigm, the traditional approach considering hedge funds as a stand-alone asset class has to give way to alternative approaches with more mature expectations. Hence the relationship between hedge fund strategies and traditional markets must be reassessed in order to introduce a more relevant SAA with hedge funds.
Lyxor’s research proposes a new model to allocate more efficiently into hedge funds per strategy type, using an asset mix perspective. Hedge fund strategies may be grouped by their exposure to common risk factors and their capacity of generating uncorrelated absolute return. When we decompose the hedge fund returns into beta return and alpha return, some hedge funds have more significant beta return than alpha return and vice-versa. Hence, some hedge funds can be categorized as equity/bond substitutes (more significant equity/bond beta return) or diversifiers (more significant alpha return).
Substitutes aim to replace the traditional assets and improve the risk/return profile of investor portfolios, whereas diversifiers generate absolute performance and diversification. This classification process with two families would allow investors to better diversify their portfolio risk and generate alpha return in a granular hedge fund world.
To integrate this new classification approach and get rid of the non-normally distributed returns, this paper also suggests a Markowitz mean-variance model with regime switching. In extreme market regimes, investors are recommended to replace a part of their long-only equities with equity substitutes to improve more efficiently the risk/return profile of their portfolio.
In normal market regimes, investors are recommended to give priority to different families of hedge funds according to their portfolio target volatility. If they aim for low, medium and high volatility, equity substitutes, diversifiers and bond substitutes are respectively preferable.
This research shows that the traditional approach is no longer adapted, as hedge funds cannot be considered as a single asset class any longer. It emphasises the necessity to analyse hedge funds by style for investors to better allocate into them. This approach will help them improve their risk/return profile in SAA more efficiently and understand the true source of this improvement in terms of risk diversification and absolute performance.

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