Hedge fund investors are moving their capital at an accelerating pace. A recent IG Prime survey reports that allocators are switching funds more frequently, citing concerns over risk, performance, and fund size.
But what if some of these allocation shifts are based on the wrong signals? In volatile markets, hedge funds should provide risk mitigation and alpha generation—so, how do allocators assess whether a manager is truly delivering on both? Investors tend to rely on track records and benchmarks, even though both can be misleading. What a manager has returned is one thing. What they should have returned is another.
Despite increasing sophistication in manager selection, many allocators still make decisions by looking in the rearview mirror—prioritizing past returns over a contextualized assessment of risk and efficiency.
For most investors, volatility is a risk to be avoided. For skilled active managers, it creates opportunity. With macro uncertainty, geopolitical tensions, and rapid liquidity shifts shaping global markets, inefficiencies are becoming more pronounced.
Not all managers extract value from volatility equally. Simply being in the hedge fund space does not guarantee thatan allocator will benefit from market dislocations. In the worst-case scenario, an allocation meant to hedge a risk can actually expose you to greater downside if the manager’s risk framework is insufficient.
With macro uncertainty, geopolitical tensions, and rapid liquidity shifts shaping global markets, inefficiencies are becoming more pronounced. Hedge funds should be positioned to exploit inefficiencies that passive investments cannot, but this only holds true if you select managers who are good at adapting to shifting risk environments.
In a volatile market, hedge funds should serve as risk shock absorbers. Investors need to ask the right questions to separate those who truly manage risk from those who survive it:
- Are they reactive or proactive? – Do they adjust strategies based on shifting risk conditions?
- Do they thrive in uncertainty? – Some strategies—global macro, distressed investing, market-neutral—are better than others in turbulent scenarios.
- How do they handle liquidity? – In stressed markets, liquidity mismatches can force managers into costly liquidations. Do they structure portfolios to withstand market squeezes?
- How are they monetizing risk? – A skilled manager will extract risk premia by capitalizing on dislocations.
Most investors evaluate hedge funds by looking at performance relative to benchmarks or peers, but this is only a partial risk assessment.
Consider two funds that each returned 12%:
- Fund A was in a market where 15-20% returns were easily achievable.
- Fund B operated in a tougher space where 8% would have been an exceptional outcome.
Looking purely at the 12% figure, they appear equal. But Fund B significantly outperformed its potential, while Fund A underperformed relative to its opportunity set.
Yet, when Fund B has an off year and returns 6%, many investors panic and pull capital—even though they might be misreading the efficiency of the investment process. A short-term dip doesn’t necessarily signal a failing strategy, it could just be part of the cycle.
If a fund returned 12% but had the potential to generate 20%, is that success or inefficiency? Conversely, if a manager was expected to return 8% but delivered 12%, they might be an exceptional allocator of risk—one you’d want to back even in a down year.
What’s the Real Benchmark?
Hedge fund performance is often judged against broad market indices or generic hedge fund benchmarks. This approach is flawed for two reasons:
- It assumes the fund’s risk-taking behavior aligns with the benchmark—which is often false.
- It ignores the competitive landscape—how did other funds within the same opportunity set perform?
A smarter approach is to compare a manager against:
- Their investable universe – What was realistically possible in their market?
- Peers with similar constraints and capital flows – Did they execute better or worse than others operating under similar conditions?
- Portfolio-level exposures – Are you getting differentiated risk, or are multiple managers making similar bets?
Aggregating Exposure Across Managers
Many investors assess hedge fund allocations individually, rather than viewing them holistically. This can lead to significant blind spots:
- Overlapping exposures – Multiple managers making similar bets can create unintended concentration risk.
- Hidden correlations – Funds that appear uncorrelated in normal markets may move together in times of stress.
- Leverage effects – Aggregated across funds, leverage may be higher than assumed.
Instead of simply checking individual manager performance, investors need a full portfolio view of risk. The goal isn’t only to diversify, it’s to ensure that your allocations work collectively to provide true risk-adjusted returns.
In volatile markets, hedge funds can be a valuable risk management tool, but only if investors move beyond simplistic performance metrics and start asking better questions.
Volatility alone is not risk: it is simply the dispersion of returns. It can be productive, when it manages to generate high risk-adjusted returns over time, but unmanaged volatility is a warning sign of poor risk control.
Some of the most successful hedge funds have periods of drawdowns yet deliver long-term outperformance. The key for investors is not to abandon a fund just because of short-term losses but to understand whether those losses are within the normal efficiency range of the strategy.
Kiski Group helps allocators optimize their hedge fund allocations. We assist with manager selection, evaluating manager performance and exposures, and designing smarter portfolio allocations. If you want to refine your hedge fund strategy, we can help.
