Can investors use hedge funds to help combat bond market volatility?

We’ve written about the challenge that excess volatility can pose to a portfolio via the “volatility tax.” We’ve also addressed how alternative asset classes are tools that can potentially help enhance returns (for example, via private equity) or reduce volatility and provide diversification (such as with hedge funds).

We believe the current environment of elevated volatility in financial markets—particularly within fixed income, where interest rate swings have become more frequent—along with the prospect of declining yields on cash, is well suited to the use of hedge funds, specifically those with an absolute return focus and limited correlation to traditional asset classes.

Volatile bond market flips portfolio math on its head

From 1989 through September 2024, the average annualized volatility for fixed income, as measured by the Bloomberg US Aggregate Index, was fairly consistent and relatively low at 3.75%. For comparison, the S&P 500’s annualized volatility over this period was elevated relative to fixed income at about 14%. It also had more volatility around that average (Exhibit 1). However, based on these historical averages of 3.75% and 14%, we would expect a 60% S&P 500/40% Bloomberg US Aggregate portfolio to have a volatility of around 10%.

Post-Covid and following the Federal Reserve’s (Fed) rate-hiking cycle from 2022 to 2023, the volatility for fixed income has been categorically higher than in any period going back to 1989. Starting from the Fed’s initial rate hike in March 2022 through September 2024, the Bloomberg Aggregate Bond Index had annualized volatility of 8%—over twice its historical average.

Today, if we take the historical average volatility of equities at 14% and use the latest trailing twelve-month volatility for the Bloomberg US Aggregate Index as of September 2024 (7.4%), a 60/40 portfolio would have an expected volatility of about 11%. The difference between the 60/40 portfolio’s historical 10% volatility and the current 11% volatility may not sound like much, but to maintain that 10% volatility target using the current volatility of fixed income means investors would need to flip their allocations to 40% S&P 500/60% Bloomberg US Aggregate.

Exhibit 1: Bond market volatility has spiked uncharacteristically high

December 1989 through September 2024. Source: FactSet

Hedge funds may help investors solve volatility-driven dilemmas

That, of course, would dramatically change the expected return profile of the portfolio. Is there something else that can be done?

We believe a hedge fund allocation can potentially help dampen the current elevated volatility in portfolios derived from fixed income while still providing a competitive return. From 1989 through September 2024, hedge fund volatility has averaged 4.8% (as measured by the HFRI Fund of Hedge Funds Index). Since the start of the Fed’s rate hiking cycle in 2022 hedge fund volatility has averaged 3.8%, a level approaching fixed income’s historical volatility level.

As a result of this lower volatility, if an investor redirects approximately half of their fixed income allocation to hedge funds they may be able to retain their 60% equity allocation and possibly achieve a portfolio volatility approaching the historical 10% target.

Consistency is the key in effective hedge fund strategies

Hedge funds can pursue a variety of different types of strategies, but many share characteristics that we believe make them appealing for the purposes of volatility reduction. These strategies often prioritize risk management, below-market volatility levels and consistent returns. They have the potential to mitigate volatility in several ways including, for example:

• Via low net market exposure—this means the portfolio’s total exposure to market volatility is lower because it contains holdings that may offset each other’s volatility.
• By employing hedges—the use of these derivatives requires paying small upfront premiums to help manage risk exposures.

Absolute return hedge fund strategies place a high priority on consistent returns regardless of market conditions. As such, in our opinion, they may be well-suited to simulate the type of steady return profile for which investors historically relied on income-oriented investments.

We use the HFRI Fund of Hedge Funds Index in Exhibit 2 to illustrate comparative volatility across the asset classes in question, but we believe the diversification benefit may be even more pronounced if investors employ hedge funds that are curated and specifically focused on absolute return strategies with limited correlation to traditional asset classes.

Exhibit 2: The volatility profile of hedge funds offers a diversification opportunity

December 1989 through September 2024. Source: FactSet