The best contributors to diversification will surprise you

Investments with hedge fund managers will generate significant diversification benefits. This has been the key selling point for managed futures and other hedge fund styles, yet a closer inspection makes for a more complex and mixed story.

Our simple review over the last three years tells a different diversification story. Buying a portfolio of managed futures managers may not be better than holding more fixed income. You should know what you are getting versus a diversification alternative and any simple blanket view is without merit.

We analyzed the long bond (TLT), the Barclays Aggregate index (AGG), and the SocGen managed futures index (CTA) against the S&P 500 index (SPY). First we compared the correlation of these three diversifiers against SPY. We then look at the risk reduction from adding 10% of each diversifier against holding just equities, SPY. We can then measure the marginal reduction in risk and the marginal return change for the time periods examined. 

This work is not definitive but should cause some careful thinking by investors before they invest in alternatives. Investors should think about the marginal diversification from a hedge fund investment. 

The best diversifier is the long Treasury bond. Call it a safe asset, but it has the greatest negative correlation against stocks. The lower duration AGG index comes in second while managed futures has the least diversification based on correlation. It also has the most volatile correlation. Of course, a longer period analysis will show that the negative correlation between stocks and bonds is variable and there have been periods when the correlation has been positive.

Risk reduction is not based on correlation alone. There is the volatility of the diversifier. A lower correlation asset with low volatility will generate more risk reduction than a higher volatility asset. In this case, the AGG index will show the lowest volatility when looking at a 90/10 combination of SPY and the diversifier. 

Nevertheless, diversification does not come without a price. We can also look at the total return of these 90/10 combinations. You may buy the low volatility asset, but the return drag may be greater than desired. In the three year period, there is more return drag from holding the AGG index, but over the one year period, AGG generates the highest gain. While looking at the return impact is not a core reason to diversifier, it frames the question of cost from hedging.

Diversification can be gained from the right mix of traditional assets, so the question of holding alternatives is more complex and should be based on a complete comparative analysis.