With markets riding high, investors are increasingly concerned that markets have topped and a correction is imminent.
However, UBS Chief Investment Office (CIO) believes the market is currently mid-cycle and there are few signs that the bull market is coming to an end. CIO said it is too early to position investment portfolios defensively, but that a downturn will inevitably come at some point.
"The challenge for investors is to avoid missing out on highly rewarding mid-to-late cycle investment opportunities while also preparing portfolios for challenges. This is especially important at a time when bonds may not offer as much insulation against equity market drops as in previous cycles," said CIO strategist Karim Cherif.
CIO said investors should maintain their exposure to risky assets, but also diversify early enough into asset classes that may perform well in more difficult markets.
"In this context, hedge funds look particularly attractive as they are typically good risk diversifiers in later stages of the cycle, able to benefit from rising interest rates, increases in volatility and dispersion, and falling correlations," said Cherif.
Hedge funds also act as an enhanced risk management toolkit, mitigating drawdowns and thereby allowing a faster recovery than traditional asset classes such as equities. CIO said on an absolute return basis, hedge funds have historically outperformed other asset classes when interest rates go up in the US. This is because most managers' range of opportunities increases.
"As rates rise, the likelihood for lower correlation and higher dispersion increases. Under such market conditions, hedge fund alpha generation is at its highest," said Cherif.
CIO said divergent central bank policies also increase opportunities for cross-regional fixed income and foreign exchange trades, for instance; discretionary macro and relative value managers can capture these.
Within CIO's longer-term strategic asset allocation strategy, CIO recommends an allocation of 14 percent to 18 percent to hedge funds depending on the investor risk profile.