This summer the Federal Reserve Board cut interest rates, and the yield curve inverted, leading many to fear that the next recession is imminent.

However, a yield-curve inversion as an indicator of recession isn’t foolproof. It’s also likely less indicative than in the past and certainly does not determine when a downturn could happen. Still, equity markets are fully valued, prompting investors to ponder how to manage portfolios and protect against the downside risk in financial markets today.

The importance of hedge funds in portfolios can lead to provocative debates. In recent years, as equity markets appreciated with little volatility, hedge fund performance lagged the traditional, long only benchmarks, leading to scrutiny of fees and structures. However, history suggests that hedge funds remain an important diversifier for portfolios, providing protection against large market drawdowns.

In the two most recent recessions, equity hedge fund strategies held up well as the S&P 500 sold off, with the Credit Suisse Long Short Equity Index experiencing just 25-35% of the equity market drawdown in both the March to November 2001 recession and the Great Recession of December 2007 through June 2009.

Expanding the analysis to include the six months prior to and following both recessions confirms the value of a hedged approach. The portfolio positioning of hedge funds ahead of a recession allowed for significant outperformance coming out of the downturn in both recessions. Actively managing exposure to hedge funds in a portfolio can prove beneficial for long-term investors.

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