Diversified sources of risk and return are essential for every investor, and hedge funds have historically played an important role in achieving this goal. While hedge funds have continued to offer diversification in recent years, there has been significant dispersion in manager performance. What can investors do to seek consistency of diversification and performance?

We suggest that investors consider alternative risk premia strategies. We estimate that roughly a third of the total risk across a broad sample of hedge fundsi is driven by traditional or alternative risk premia. However, risk premia can be accessed at much lower cost and with higher liquidity. We believe investors can get more from their hedge fund allocation by selectively replacing part of their portfolio with exposures to alternative risk premia.

Revisiting recent hedge fund performance

The broad hedge fund universe returned 3.8% annualized over the seven years ended December 2016, compared to the 7.9% return from global equities and the 4.0% return from fixed income (see Figure 1). The difference in performance versus equities should not be surprising: Strategies designed to diversify away from equities are not likely to fare well during a strong equity bull market. Furthermore, unprecedented central bank intervention over this period has suppressed volatility in financial markets, creating a challenging environment for strategies designed to capitalize on market dislocations.

There has also been a high degree of dispersion in performance among hedge funds, as shown in Figure 1. Top-quartile hedge fund managers in our broad sample delivered an annualized return of 9.2%, handily outperforming the median hedge fund manager by 3.5 percentage points per annum. The top performers (95th percentile) delivered 17.1% in annualized return, outperforming peers and the broad market by an even wider margin. This highlights the importance of manager selection. However, while everyone desires an allocation to star performers, finding them on a consistent basis is challenging. Some of the top funds are capacity-constrained and thus closed to new investors.

Critically, investors evaluating hedge fund allocations shouldn’t focus solely on the level of performance versus traditional assets, as is often the case. They should also look at where the performance comes from. A truly diversifying asset can be useful in portfolio construction even if its stand-alone returns are lower than or similar to those of traditional asset classes.

Dissecting hedge fund risk

Underlying risk in a hedge fund, or for that matter any active strategy, stems from exposure to three sources: traditional risk premia, alternative risk premia, and alpha (see Figure 2). Traditional risk premia represent returns attributable to broad exp