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How Much Hedge Fund Exposure Makes Sense?

January 2, 2013

by Daniel Eagan

of AllianceBernstein

Our research suggests that a well-diversified allocation to hedge funds might improve portfolio returns, but their greatest benefit is the risk reduction that comes from their low correlation to stocks. Here’s why.

Our approach to asset allocation to hedge funds starts with our experience. Most investors, we have found, can accept a 10% decline in their wealth, but find losses on the order of 20%—which may force them to consider lifestyle changes—excruciatingly painful. After two bear markets in the past 10 to 12 years, many investors have significantly de-risked their portfolios, primarily by shifting a significant part of their portfolios from stocks to bonds or cash.

So we looked at the probability of a 20% peak-to-trough loss for portfolios with various asset allocations. For an investor with 60% of assets invested in equities and 40% in bonds, we found that allocating 14% of the portfolio to hedge funds would reduce those odds from 27% to 18%.

To determine the optimal allocations, we applied a mean-variance optimization to identify the hedge-fund allocations that would maximize portfolio return on risk. The optimal allocation to hedge funds grows with an investor’s risk tolerance, from less than 10% to about 25%, as the display below shows. For a 60/40 investor, it’s about 14%.

Investors' Objectives and Risk Tolerance Drive Our Optimal Allocation to Hedge Funds

When building our optimal portfolios, we sourced the allocations to hedge funds from the allocations to all other investments on a pro rata basis, because this adds to potential return while reducing risk. But investors have a range of choices. To reduce risk even more, an investor could source the entire hedge-fund allocation from stocks.

Until the 2008 credit crisis began, many investors believed that certain types of hedge funds could be used to replace bonds completely. Our finding that hedge funds have provided less reliable diversfication benefits than bonds during stock-market drops suggest that this use would be imprudent. Sourcing the entire hedge-fund allocation from bonds would add substantially to portfolio risk.

In sum, our research suggests that a well-diversified, moderate allocation to hedge funds reduces the likelihood of a 20% peak-to-trough loss for the overall portfolio. This feature is particularly useful today, when extremely low bond yields make substantial investments in higher-returning assets crucial to funding long-term spending goals, and equity volatility remains daunting for many investors.

However, hedge funds pose particular risks not captured by their volatility, including the uncertainty of alpha, an unstable correlation to stocks, and potentially higher illiquidity in a market crisis, particularly if the funds are highly leveraged. Rigorous due diligence and broad diversification across managers and categories are essential to mitigating these risks.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future.

Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Daniel B. Eagan is Head of the Wealth Management Group at Bernstein Wealth Management, a unit of AllianceBernstein.

© AllianceBernstein