Hedge funds - substitutes or diversifiers? - that is the question

The CAIA and AIMA groups developed a hedge fund framework for trustee which provides a good introduction on how to classify hedge funds for a portfolio. Cutting through all of the issues of alpha and beta focuses on two large groupings, substitutes and diversifiers. Now all hedge funds will provide some diversification versus a traditional equity and bond investment, but the degree of differences matters. 

The substitutes are those hedge fund strategies that can fill-in as an alternative to a equity or bond investment with less risk. If an investor does not want as much directional risk, he can sell bonds and buy a fixed income arbitrage fund. If an investor wants less directional equity risk, he can buy a long/short equity fund. There will be exposure to stocks or bonds but at a lower beta and a higher likelihood of alpha.

The diversifiers are hedge fund styles that will provide a greater degree of diversification because the correlation will be low and potentially negative during "bad times", those periods when equities do poorly. The diversifiers include managed futures, which have low correlation during crises, global macro which will take large beta bets from both the long and short side of the market, and equity market neutral which reduces most of the market beta.

Substitutes look to lower volatility and add alpha. Diversifiers look to dampen volatility through dynamic beta. This simple framework makes the question of choosing hedge fund styles very simple. Do you want a substitute for market exposure, or do you want diversification protection? Answer the macro question and then focus on the right managers within these two major classification.