Hedge Fund Roles – Wellington

Hedge Fund Roles

Today’s post looks at a recent paper from Wellington Management on hedge fund roles.

Wellington

I haven’t come across Wellington before (probably because they work with institutions rather than private investors), but according to their website:

Wellington Management has been managing assets on behalf of UK institutions for more than two decades. Our clients are corporate and local pension schemes, endowments and foundations, insurance companies, financial intermediaries and family offices.

The paper was published in March 2024 and aims to identify the type of hedge fund most suitable for various roles in a portfolio.

We’ve developed a simple and intuitive framework that focuses on the role each portfolio building block is meant to play and can help identify sources of funding from within existing portfolio allocations.

Hedge fund types

Wellington distinguishes four types of hedge funds:

  1. Event-driven (bankruptcy, merger/acquisition, the involvement of an activist investor)
  2. Equity long/short funds (which despite their name, tend to have directional exposure to equity markets)
  3. Relative value funds (which use multiple asset classes to achieve low to neutral overall market exposure and returns similar to an income stream)
  4. Macro funds (which use top-down views on economic policy and all asset classes to provide absolute returns when markets are selling off)

There are also multi-strategy funds which aim to generate a more stable risk and return profile than single-purpose funds.

  • This diversification comes at the cost of lag when a particular type of strategy has a strong rally.
Hedge fund roles

Role classification (7 Circles)

Wellington also identifies four roles for hedge funds:

  1. Return consistency: offering steady returns that can compound over time
  2. Return enhancement: increasing the overall performance of the portfolio
  3. Diversification: broadening the portfolio to include additional distinct sources of return
  4. Downside protection: limiting losses during significant market downturns

The table above shows which type of funds suits each of these roles.

Problems with 60/40

Funding sources (7 Circles)

The next table looks at where stocks and bonds (and the classic 60/40 mix) are coming up short.

Equities are generally expected to provide return enhancement. On the other hand, investors typically seek return consistency, diversification, and downside protection from their fixed income allocations. And a 60%/40% portfolio may offer more balance across the roles.

The key times when investors with a 60-40 want help from their hedge fund allocation (or indeed, their allocations to any diversifiers) are:

  1. When stocks are down (Wellington looks at drawdowns of 10% or more)
  2. When fixed-income returns are negative.
Stocks down

Equity downside protection (7 Circles)

When equities had a drawdown of more than 10%, a simple 50%/50% combination of macro and relative value hedge funds provided downside protection in almost all instances — even when fixed income did not, as in 2022.

Bonds down

Fixed income downside diversification (7 Circles)

When fixed income returns were negative, the same simple combination of macro and relative value hedge funds performed well.

Implementation

Adding to a 60-40 (7 Circles)

Wellington looked at three goals for adding hedge funds to a 60/40:

  1. Return enhancement
    • This is similar to the equity role and would be funded from the equity allocation
    • Equity long/short and event-driven are useful here
  2. Improving return consistency, diversification and downside protection
    • This is the bond role and would be funded from the bond allocation
    • Macro and relative value are most useful, with a small allocation to equity long/short
  3. Creating balance
    • This is the diversified 60/40 role and would be funded from both the stocks and bonds allocation
    • All four types of hedge funds have a role to play here.
See also:  Good Robot? US Robo-Advisors

That’s it for today.

  • It’s been a useful breakdown of the hedge fund space, and how to best use the various flavours.

As usual, the problem for private investors in the UK is implementation.

  • In the UK we only have access to a Macro hedge fund, plus a few investment trusts with adjacent approaches.
  • In the US there are half a dozen funds, though they are mostly blends.

For the other three flavours, UK investors would have to try a DIY approach, which might be difficult, expensive and possibly dangerous.

  • Until next time.

Mike is the owner of 7 Circles, and a private investor living in London. He has been managing his own money for 40 years, with some success.

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Hedge Fund Roles – Wellington

by Mike Rawson time to read: 2 min