Model Hedge Fund Portfolio

BNY Mellon uses a model portfolio with 55% stocks, 30% bonds, and 15% hedge funds in their annual report of market predictions. What does this look like for a retail investor using available mutual funds and ETFs, and specifically using hedge funds packaged in mutual fund format?

Previously I wrote about this, calling it a “hedge fund portfolio”. By this I just mean a typical portfolio of stocks and bonds, but with an added allocation of liquid alts (hedge funds in a mutual fund wrapper). Hedge funds are designed to have low correlation to both stocks and bonds, so adding them to the portfolio lowers the risk. Remember, hedge funds are boring; they aren’t supposed to return as much as stocks. Adding them reduces the expected returns by a little, and reduces the expected volatility by a lot. So with a carefully added amount of leverage a hedge fund portfolio matches the risk of a typical portfolio and beats the returns.

So adopting the BNY Mellon asset allocation, we have the following Retail Hedge Investor model portfolio:

This portfolio implemented with simple index funds and traditional hedge fund strategies from companies like Vanguard and Pimco has beaten the returns of the S&P 500 over the past 1-year, 5-year, 10-year, and 20-year periods:

Here is the full range of historic returns since 1999:

If you click on the chart above you can see the specific funds used to implement this portfolio. The two liquid alt funds in this portfolio were chosen because they are the two oldest hedge funds available to retail investors, and they have historic data going back to 1999. The first fund is a standard statistical arbitrage fund from Vanguard and the other is event-driven fund from Virtus. Ideally we would also include a managed futures hedge fund, and I will discuss more about each of these strategies in the future.

Rational for the model portfolio

There were a few reasons for following the BNY Mellon 55/30/15 portfolio allocation. You can actually improve the risk adjusted returns by reducing the amount of stocks and increasing the bonds and hedge funds, but I’m choosing not to do so. An allocation like 40/40/20 of stocks/bonds/hedge funds has historically had better risk adjusted returns, but that allocation would require a larger leverage multiple to bring it up to S&P 500 level volatility. I have specific leverage instruments that I want to suggest in the future that have an upper limit of around a 2x leverage multiple. There are many different reasonable choices for the level of equities included and the corresponding leverage multiple that fits with that choice, but this is a standard asset allocation to work with and will be our model portfolio going forward.

A few things to note at this point: this model portfolio is an intentionally aggressive portfolio. It is as volatile as a portfolio of 100% stocks, so this is not a recommended portfolio to hold as your entire investment allocation. This could be held as a portion of your investments, or could make up your entire portfolio if the leverage was calibrated to your specific time horizon.

Also, it does not outperform the S&P 500 in every time period. It has higher total returns over the last 1-year and 5-year periods, but that is misleadingly positive. Over the past three years long duration treasuries had their equivalent of a Great Depression and any portfolio holding them was severely impacted. So while 1-year and 5-year returns look positive, it lagged over the last 3-year period and the risk-adjusted returns were below that of the S&P 500 over all of these time periods.

I’m highlighting this negative performance not to show some fault with leveraged-diversified strategy, but rather to reinforce that we do not expect this strategy to perfectly match the direction of the S&P 500 over these short time horizons. If you follow this portfolio over the next twelve months, do not be surprised if it lags the market by 5-6%.. In any typical year you should expect about that much deviation from the S&P 500 for this portfolio. And the same goes for outperformance: don’t be surprised if this portfolio outperforms the S&P 500 by 5% over the next 12 months, but that is higher than what we should expect over the long term. Over the past 10 years the outperformance was roughly 2% annualized, and that is typical for all rolling 10-year periods over the last half-century.

This model portfolio will provide a basis for further analysis of a leveraged, hedge fund portfolio. We will look at what to include in each of the stocks, bonds, and liquid alts portions, with the greatest focus on the liquid alts. We will also analyze the leverage portion of the portfolio, looking at different options for implementing the leverage and finding an upper bound for the interest rate on the leverage where it stops being beneficial.