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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 (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

        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.