Another dawn for hedge funds?

Introduction

Low interest rates and subdued volatility in the 2010s saw investors rely heavily on equity beta. When interest rates and market volatility rise, this approach may not suffice. This has renewed interest in hedge funds, which are a subset of alternative strategies. They aim to deliver uncorrelated and enhanced returns, while diversifying risk.

This article examines the evolving role of hedge funds within investor portfolios, particularly in the context of changing market dynamics. It also assesses avenues of exposure available to retail and advisor-directed investors.

Hedge funds span a range of subcategories, each with suitability determined by an investor’s risk tolerance and objectives. The following link provides resources from our Global Manager Research team on effectively integrating liquid alternatives into a portfolio.

How to Approach Liquid Alternatives in Your Portfolio in 2025

State of play: The role of hedge funds

The backdrop

Allocations to alternatives have steadily increased over the past decade on a per-fund basis among Australia’s most influential allocators: superannuation funds. Most subcategories—including unlisted infrastructure, unlisted real estate, private equity, and private credit—have risen in tandem.

Part of this growing appeal for alternatives may lie in the challenging outlook for traditional assets. Many leading economists expect lower annualized returns for traditional asset classes and higher volatility for global equities and typically diversified portfolios—for example, the 70/30 equity/bond mix—over the next five to 10 years compared with the last five.

In contrast, the past five years delivered mid-double-digit annualized returns from global equities, reducing investors’ reliance on alpha—loosely defined as excess returns generated by manager skill—with beta, or broad market exposure, doing most of the heavy lifting. With forward-looking market returns expected to fall, a greater share of total returns will need to come from alpha—which is where alternatives can play a crucial role.

Hedge funds, however, have been an exception, standing out as one of the few alternative categories experiencing a decline in allocation over the last decade. Much of this may have been due to an unfavorable macroeconomic backdrop, with the period characterized by stable inflation and an ultralow interest rate environment—conditions that typically work against many hedge fund styles.

For example, ultralow interest rates reduce the yield available from cash or low-risk assets—a drag for many hedge fund approaches that hold significant cash or collateral. Meanwhile, stable inflation and calm markets limit the volatility and mispriced opportunities on which many hedge funds rely.

The backdrop has since shifted—and so too has sentiment among institutional investors toward hedge funds.

Rising dispersion, rising opportunity

Institutional interest in hedge funds has rebounded in recent years, with industry data showing a notable increase in search activity. While equity mandates have remained relatively stable, hedge fund searches now represent a meaningful share of institutional attention.

This renewed interest coincides with a broader reassessment of portfolio construction approaches in response to macroeconomic disruption. Since covid-19, several factors—including geopolitical tensions, economic uncertainty, and, most notably, the persistent rise in inflation—have driven institutional investors to reconsider alternative diversifiers, particularly uncorrelated hedge fund styles.

Geopolitical tensions and economic uncertainty have led to increased dispersion within and across markets, presenting greater opportunity for hedge fund managers. Dispersion refers to the degree of variation in returns across individual securities and groups like stocks, sectors, and countries. It describes the gap between winners and losers, in simple terms.

Dispersion metrics have been trending higher on average between the 2010s and 2020s, creating a more fertile environment for hedge funds. This helps explain their diminished role in prior years and supports the notion that a regime shift may now favor their reintroduction in portfolios.

Diversifying beyond bonds

But perhaps the primary reason that institutional investors—who often pave the way for retail and advisor-led investors—are turning to hedge funds is the heightened difficulty of achieving effective diversification in an environment where traditional stocks and bonds are increasingly moving in tandem.

Empirical evidence shows a statistically significant relationship between inflation levels and the correlation between equity and bond returns. Put simply, this relationship is driven by shifting interest rate expectations. Higher inflation typically leads to expectations of tighter monetary policy—including higher interest rates—which tends to be bearish for both bonds and growth equities, driving their returns in the same direction and increasing correlation.

Over the past 20 years, correlations between bonds and equities have often tended to turn positive when inflation in advanced economies averages above 2%. With this threshold expected to be breached over the next five years, investors may increasingly seek exposures with clearer and more-differentiated portfolio roles. Certain hedge fund classes targeting uncorrelated returns may provide more-reliable diversification benefits while also being less vulnerable to the erosive effects of inflation.

Exhibit 1: The link between inflation and equity–bond correlation

Rolling 12-month correlation between MSCI World (Equities) and Bloomberg Global Agg (Bonds) vs. inflation.

Source: Morningstar Direct, IMF World Economic Outlook. Data as of Aug. 12, 2025. Note: At rescaled weights, roughly negative 0.5 corresponds to an inflation rate of 2%.

Exhibit 2: Inflation rate, average consumer prices

Annual percentage change

Source: IMF World Economic Outlook. Data as of Aug. 12, 2025.

Harnessing the opportunity: Putting hedge funds to work

10,000 choices

Despite declining local allocations, the global hedge fund industry has grown roughly threefold over the past decade, with two types of offerings—multimanager hedge funds and specialized hedge funds—coming to dominate the landscape.

Specialized strategies, which number more than 10,000 across at least three dozen classifications of hedge funds, provide targeted exposures tied to specific investment styles. The following are a few examples of key hedge fund classes, each exhibiting varying degrees of correlation with global equity markets and differing levels of volatility relative to those markets, as illustrated in Exhibit 3.

Exhibit 3: Global hedge-fund categories

3-year correlation and relative volatility vs. global equities

Source: Morningstar Direct. Data as of Feb. 28, 2025.

Event Driven

Targets opportunities from corporate actions such as mergers, acquisitions, or restructurings, with returns driven by specific events.

Equity Market Neutral

Maintains balanced long and short positions to reduce exposure to overall market movements, aiming for consistent, low-volatility returns from alpha.

Macro Trading

Takes long and short positions across global asset classes, including equities, bonds, and currencies, aiming to profit from market inefficiencies while potentially providing diversification benefits.

Systematic Trend

Employs quantitative models to identify and follow price trends across asset classes such as equities, bonds, currencies, and commodities, with returns driven by momentum signals rather than fundamental views.

By comparison, multimanager hedge funds combine multiple specialized hedge fund strategies under a single fund and may traverse different asset classes and investment approaches. They typically aim to deliver attractive risk-adjusted absolute returns with a low correlation to broad markets and a focus on preserving capital. On the surface, multimanager funds appear to represent the most conceptually appropriate access point.

However, Exhibit 4 shows that, in practice, both specialized and multimanager funds exhibit a similar range of correlations with equity markets and relative volatility as the various categories of specialized funds. This highlights that, regardless of fund type, investors should ensure that the objectives of the underlying strategies align with their own when seeking diversified, defensive exposures described earlier.

Exhibit 4: Multimanager hedge funds

3-year correlation and relative volatility vs. global equities

Source: Morningstar Direct. Data as of Feb. 28, 2025.

Opening the door to retail

So, while institutional investors are already rotating into hedge funds, where does that leave retail and advisor-led investors?

Retail and advisor-led investors seeking traditional hedge fund exposures face significant barriers to entry—among them, high minimum investments, eligibility restrictions requiring high-net-worth or institutional status, limited transparency, complex fee structures, and liquidity constraints. Together, these factors have discouraged participation.

While many traditional hedge funds still carry these barriers, growth in liquid and semiliquid alternatives, combined with strong demand for innovation, has prompted the industry to evolve, creating products that are more accessible, more liquid, and more cost-efficient for a broader investor base.

Liquid hedge fund strategies can help mitigate some of the traditional hedge fund shortcomings:

Greater accessibility, with lower minimum investments typically between AUD 5,000 to AUD 20,000.
Simpler structures, offered through more investor-friendly vehicles.
Lower and better-defined fees, reducing the cost burden on investors.

And of course:

More flexible liquidity, offering daily subscription and redemption terms versus what are generally monthly, quarterly, or annual windows with potential lockups.

Importantly, liquid alternatives are subject to the same regulatory standards as traditional managers, improving transparency and investor protection. Australian regulatory reforms since 2020 have further compelled managers to enhance disclosures and create clearer pathways for retail and advisor investment in liquid alternatives.

Key initiatives, such as the implementation of design and distribution obligations, the establishment of target market determinations, and enhanced enforcement measures, have improved product suitability communications and fostered more active engagement between managers, advisors, and investors.

Understanding the trade-offs

Much has been made of the complications that can arise from combining illiquid assets with liquid vehicles, including here at Morningstar. However, unlike private markets or different alternative subcategory managers offering liquid vehicles—such as those in private credit, private equity, or direct infrastructure—many hedge fund managers already invest in highly liquid underlying markets, like equities, bonds, foreign exchange, and derivatives.

Lower liquidity mismatches—the gap between the liquidity of the fund and its underlying assets—reduce overall investment risk from volatility amplification (larger swings in the fund’s value), forced sales (having to sell assets quickly, potentially at a loss, to meet redemptions), liquidity risk (difficulty selling assets without affecting their price), and valuation uncertainty (not knowing the precise value of less liquid assets at a given time).

However, an inherent limitation remains: Not all hedge fund strategies invest exclusively in liquid asset classes. As a result, liquid alternatives do not provide like-for-like exposure with traditional hedge funds, particularly multimanager strategies that benefit from the full suite of hedge fund subcategories.

This can lead to lower absolute returns, as reduced exposure to illiquid hedge fund subcategories within multimanager strategies means less participation in the liquidity premium. Nonetheless, this does not diminish the total portfolio risk/return improvement that a well-constructed allocation can provide, as discussed.

Conclusion

Rising inflation, higher interest rates, and greater market dispersion and volatility have highlighted the potential role of hedge funds as diversifiers. Retail investors now have increasing access to liquid and semiliquid hedge fund options that offer lower minimums, simpler structures, transparent fees, and daily liquidity.

While these vehicles don’t perfectly replicate traditional hedge funds and may deliver lower absolute returns, they still provide diversified, defensive exposure and potential sources of alpha. By considering strategy objectives and liquidity alongside personal risk tolerance, retail investors can thoughtfully include hedge funds as part of a broader portfolio.

The table below highlights noteworthy and emerging Australian liquid hedge fund strategies.

Both multimanager and specialized strategies can support improved portfolio outcomes, depending on their investment objectives. The strategies included in this table target low correlation to equity and bond markets, capital preservation, and consistent absolute returns.