The Case for (Some) Hedge Funds

Only a small percentage of the world’s 11,000 hedge funds merit institutional capital, says Cambridge Associates—but the few good ones still bring “real value.”

Don’t dump your entire hedge fund portfolio just yet.

Despite recent poor performance and high-profile divestments of the much-maligned alternative managers, hedge funds can still provide “real value” as a hedge against market fluctuations, Cambridge Associates has argued.

“There is no doubt that hedge funds have provided a counterweight to equity and bond investments in a portfolio,” said Trudi Boardman, a senior investment director at the consulting firm’s London office.

According to Cambridge Associates, some investors have “lost sight of the role that hedge funds are meant to play in an investment portfolio—as a protector against downside risk.” This “forgotten benefit” will prove useful as “political and other shocks… exacerbate an already challenging situation for many pension schemes, which are facing a widening funding gap as a result of persistently low interest rates,” the consultant said.

“We’ve been executing alternative investment programs within institutional portfolios for more than 30 years and have witnessed the value that hedge funds have brought to investors who have maintained a long-term mindset and an ability to weather various market cycles, including periods of underperformance,” Boardman said.

During previous market crashes, hedge fund investments have helped institutional investors limit their losses, the consultant found. For example, in September 2002, when the MSCI All Country World Index fell by 12.5%, a portfolio with a 20% allocation to hedge funds only lost 4.6%, compared to the 6.9% loss suffered by a traditional 60/40 portfolio.

“Capital preservation during bear markets enables low beta-high alpha hedge funds to capture the long-term benefits of compounding returns,” said Managing Director Joseph Marenda. “Strategies that may appear volatile in isolation, such as managed futures and global macro, can be strong diversifiers in the context of a traditional scheme portfolio due to their zero-to-low correlation with traditional asset classes.”

There is, however, one catch: only a small number of hedge fund managers actually get the job done, according to Cambridge Associates. The consultant recommends just 250—about 2%—of the world’s nearly 11,000 hedge funds.

“Performance dispersion across hedge funds is larger compared to traditional asset classes,” Boardman said. “Therefore manager selection (only paying high fees to those who can really generate alpha) is critical.”

Related: GMO: Now is the Time for Hedge Funds