The BlackRock Investment Institute announces that investors should increase their allocation to hedge funds. It is not clear what the rationale is for this increase. Equity markets are overvalued and bond yields are not expected to move lower. Private equity is facing liquidity issues. Hence, hedge funds are a safe haven by default. As a diversifier, hedge funds may do the job, but the story should be more nuanced. Stock-picking has improved with market dispersion, but many hedge funds have relatively high betas. If the market moves lower, hedged funds will likely also see lower returns, albeit muted.
The choice of hedge funds and the allocation are related to a market view. If there is a view that equity and bonds will not perform because of the macro environment, investment strategies should be focused on managed futures and global macro. For equity exposure, market neutral should be preferred.
However, there is a bigger issue associated with fund flows. If there is limited alpha, what will happen to returns if there is a major increase in fund flows into hedge funds? There has not been enough work on the flow effects on alpha returns. More money chasing the same number of opportunities will lead to lower returns. Part of good investing is being in strategies before the "big money" enters the trades.
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