Putnam's categorization of hedge funds - classification matters


A good stating point for any discussion about alternative investments is defining terms and providing a classification system for strategies. Without definitions and classifications, no serious discussion on costs or benefits can be undertaken. Putnam Investments has done a good job of providing a useful framework. This framework further moves the discussion forward through providing an analysis of which strategies do well based on different economic environments. This look at conditional behavior  is a good research advancement.

The Putnam breakdown is a deeper take on the CAIA classification system of substitutes and diversifiers. Here the main breakdown between "zero beta" styles and volatility dampeners which could be a proxy for substitutes. The inflation hedge and return enhancers are more outlier to the first two categories. It is notable that Putnam and CAIA place global macro in different buckets. This is why thinking about classifications is important. 

Breaking down behavior across the 2x2 matrix between up/down growth and up/down inflation shows that performance will vary with the economic environment. Having an economic view will impact the allocation and performance of alternatives. Nevertheless, the best combination is to look at return enhancers like private equity and risk reducers like multi-strat and global macro. This seems consistent with the behavior of many pension plans which have moved into private equity and have kept allocations to global macro as a risk offset. 

We conclude that just holding a diversified basket of alternative investments is not good enough in a changing environment. Investors still need to have an economic view to get the most out of their alternatives portfolio.