Hedge Funds Are Not An Asset Class

Capital Generation Partners (CGP), an investment advisory firm, analyzed portfolio diversification ideas.  They concluded that there are only three asset classes:  debt, cash and equity.  Alternative investments such as hedge funds should not be classified as an asset class.  They should be classified based on their underlying positions.  Hedge funds are merely investment strategies for these assets.  There are four strategies based on two points:  directional versus arbitrage and systematic versus discretionary.  These four strategies and three asset classes combine to create twelve buckets.

Equities
directional & discretionary - equity long/short, long only, real estate, private equity and 130/30 funds
directional & systematic - equity index trackers and quantitative funds
arbitrage & discretionary - equity market neutral and event/risk arbitrage
arbitrage & systematic - equity statistical arbitrage and systematic CTAs

Cash & Commodities
directional & discretionary - global macro, physical commodities and currency (carry) trading
directional & systematic - trend following CTAs, commodity ETFs and money market funds
arbitrage & discretionary - commodity/macro curve trading and volatility arbitrage
arbitrage & systematic - statistical arbitrage and systematic CTAs

Fixed Income
directional & discretionary - fixed income long/short and distressed debt
directional & systematic - bond indices
arbitrage & discretionary - global macro and structured credit
arbitrage & systematic - fixed income arbitrage and systematic CTAs

Proper diversification includes having non-correlated assets in a portfolio.  CGP analyzed returns from 2000 to 2010 for the twelve categories.  Their conclusions were:

• Alternative investments are not real diversifiers of a traditional equity/fixed income portfolio
• Hedge funds should be allocated across the twelve categories and not be treated as a separate asset class
• Fund managers should be closely monitored for style drift
• Correlation map indicates that larger allocations should be made to hedge funds

The correlation heat map from the paper confirms an earlier study by Welton Investment Management.  Global macro and managed futures (Barclays CTA Index in this case) are not correlated to other hedge fund strategies.  In CGP's chart, equity market neutral can be added.

The source for this article can be accessed here.