Many investors with portfolios of stocks and bonds expect the former to deliver long-term growth and the latter to deliver steady income and stability. Recent market moves have challenged the assumption that bonds can help balance a portfolio. Global sovereign yields are rising amid an oil supply shock and inflation fears. Fiscal sustainability concerns in France and Italy pushed spreads between French and Italian 10-year bond yields and German Bund yields to multiyear highs last week. So, what can investors do?
We believe the current economic and market backdrop increases the appeal of alternative investments, including hedge funds, as a source of returns that depends less on “traditional” asset classes.
But investors should also focus on hedge funds’ diversification opportunities and their potential role as a complement to traditional investments and a source of returns that depend less on stock and bond moves.
For investors concerned that traditional stock-bond diversification may not work, the goal may be to seek either returns that depend less on stock and bond markets or assets that are less volatile in turbulent times.
Within the hedge fund universe, three areas can play a particularly useful role in diversified portfolios:
Discretionary macro. In this strategy, managers interpret economic developments and policy shifts, taking long and short positions across currencies, rates, equities, and commodities.
We like macro funds today because elevated interest rates and less predictable policy create a wider range of possible outcomes across growth, inflation, currencies, and yield curves. As central banks respond differently to domestic conditions, this creates more opportunities for hedge fund managers to express tactical views without requiring a single directional view on interest rates.
CIO analysis on discretionary macro’s historical performance shows that the BarclayHedge Global Macro Index (a proxy) delivered returns similar to those of global developed market equities (MSCI World) but with about a third of the volatility and a much smaller drawdown than the maximum drawdown of 54% for stocks.
Global macro can also provide meaningful diversification for conventional stock-bond portfolios, although it is not completely independent of them. Results vary widely among managers, so selection and diversification across managers matter.
Fixed income relative value (FIRV). In this approach, managers buy and sell related securities to exploit pricing discrepancies, rather than primarily positioning in ways that depend on whether yields rise or fall. These positions typically use leverage, and crowded trades can suffer sharp losses when markets move abruptly.
In the same analysis covering the period between 1997 and August 2026, the BarclayHedge Fixed Income Arbitrage Index (a proxy for the strategy) delivered annualized returns of 5.6% and volatility of 4.3%, less than one-third of equity volatility (MSCI World).
The strategy’s return correlations with equities and bonds (0.41 and 0.09, respectively) suggest lower sensitivity to bonds and moderate sensitivity to stocks, which may help diversify portfolio returns when public stock and bond market returns are choppier.
Multi-strategy platforms. By combining specialist teams trading different strategies within one fund, central management in this type of hedge fund strategy reallocates capital as opportunities change, while independent risk teams monitor positions and concentrations. Returns can therefore come from several sources of manager skill, rather than relying on a single manager or a specific macroeconomic or market scenario.
We believe such a structure may offer investors a practical route to diversified hedge fund exposure and potentially steadier returns.
How to fit hedge funds into a portfolio
CIO recommends allocating 8-12% of a traditional multi-asset portfolio to hedge funds. We provide an illustrative defensive hedge fund portfolio that may suit investors seeking diversification and potentially smoother returns. In this illustration, roughly 40% of the hedge fund allocation goes to relative value strategies, roughly a third to macro/trading, and the remainder to equity hedge and event-driven strategies. Under our long-term capital market assumptions, the approach has an annual return target of 5.5-6%, with about 5% volatility. These are model assumptions, not promised results or limits on potential losses, and do not account for illiquidity-related risks. Short-term outcomes can differ materially from these long-term assumptions.
Investors in alternative assets, including hedge funds, must be willing and able to bear their unique risks, including illiquidity, complexity, and use of leveraged instruments.
