With the increase in ’40 Act alternative investment fund offerings, there is greater interest in how to use these funds to help diversify portfolio risks effectively. There are a number of classification schemes that often overlap with some traditional mutual fund categories. Hence, there is an issue of how to best classify the set of both traditional and alternative offerings.

Classification Challenges

For example, there are long/short equity and credit funds. Should these long/short managers be classified within equity and fixed income categories, or should they be given their own classifications? The key difference may be the flexibility to go short within the asset class. The flexibility allows for greater fluctuation in beta and an increase in alpha potential. Is the difference just the net beta exposure, or is there true alpha production? Is a long-only credit bond that has a wide mandate and can show large fluctuations in duration more like a long/short credit fund?

How are managed futures funds different from global tactical asset allocation or multi-strategy funds? Both strategies will invest across asset classes, and in some cases, both will use trends to make investment decisions. Again, the key differences are the ability to go short with a broad set of investment alternatives, a focus on momentum, and a focus on liquid derivatives. The focus on these three factors suggests that managed futures will have a better opportunity to gain during periods of dislocation than a tactical asset allocation fund.

Classification Criteria

You can classify by instrument characteristics, or you can classify by strategy or behavior. Still, ultimately, there should be classification by what strategies do or should do based on the economic and market environment faced. Picking strategies for the environment is more critical than picking style categories. A link to economic events drives correlation across strategies, so the style is related to the environment, but a sense of the environment is more critical.

Understanding Hedge Fund Behavior

We have often classified hedge fund behavior as convergent and divergent. The convergent trader has a worldview based on mean reversion or movement back to some equilibrium. The focus or driver for returns is stability or normalcy. Divergent trader makes money when there are large market dislocations that will often be consistent with large trend moves. Divergent strategies will do well when markets are in transition.

These provide a way of thinking about fund choices based on the market environment. How will managers do in different environments? Past performance or correlation is not as important as walking through future scenarios that will suggest when managers will do well or when they will underperform.