Hedge funds have traditionally promised to give investors an edge. Yet in this uncertain investment environment, the appeal of the asset class has taken another turn – one that potentially offers a great deal more promise. When markets are unpredictable and the macro-economic picture is uncertain, hedge funds tend to offer a defensive investor backstop.
The investment case is also supported by history. This is within the context that for most of the past decade, the hedge fund industry struggled to generate alpha, as low volatility led to fewer trading opportunities while near- zero interest rates hindered the asset price discovery process.
But then came the tightening of monetary policies, which have created a macro environment characterised by greater volatility – which should (and the emphasis is on “should”) lead to better investing opportunities for hedge funds. That is to say historically, when equity and fixed income volatility increases, hedge fund alpha generation also improves. This scenario, keen investors will note, occurred last year.
So the hedge fund industry has displayed a positive relationship between higher inflation and higher interest rate regimes with better hedge fund performance, according to research by Goldman Sachs.
Furthermore, during times of low inflation, hedge funds have generated absolute returns that are around half (52%) of those available to equity investors.
But in periods of high inflation, hedge funds have materially exceeded US equity market returns, based on the same research. The lessons are clear here, and evident of where we are now.
Another factor in favour of hedge funds is the breaking of the traditional stock-bond correlation. This has some investors concerned that it will limit the traditional foundations the correlation is built upon, creating an obvious opportunity for hedge funds to fill the gap.
Meisan Lim, managing director of hedge fund research at Cambridge Associates, says the current environment is ideal for hedge funds. “More than at any time in recent history, both equities and bonds have been sensitive to macro events, particularly to inflation prints,” she says. “During periods of large positive US inflation surprises, macro hedge funds have tended to do better than a typical 60/40 portfolio.
“Conversely, when inflation has surprised materially to the downside, these managers have underperformed 60/40, though still managed to generate positive returns,” she adds. In addition, Patrick Ghali, managing partner at Sussex Partners, gives a nod to the fact that hedge funds appeal in the current environment, but with an added variation. “Institutional investors usually value more predictable return streams with less volatility, but not all of them want to have a large exposure to private assets. Hedge funds provide that type of return stream while still being liquid and without questions over valuations – as can be the case with private assets.”
Additionally, Ghali says, hedge funds can provide low correlation or “defensive characteristics” to support the overall portfolio in times of stress. It was this defensive/low correlation that was extremely attractive to investors in 2022, given the chaotic market environment.
A different world
Ben Cooper, head of manager research at Cardano, the investment firm behind Now Pensions, says that diversification away from traditional asset classes, such as bonds or equities, is a key reason why investors turn to hedge funds. “Yet not all hedge fund strategies fill the gap created by the breaking of the traditional stock-bond correlation,” he says.
Although he adds: “The term hedge fund is broad and encapsulates a range of strategies where diversification potential varies greatly,” he says. “For example, we would expect a trend- following fund to offer a different return profile to a long-biased equity long/short fund over the medium to long term,” Cooper says.
For all that though, he questions whether institutional investors are turning to hedge funds? “It’s not clear cut,” Cooper says. “And it is very much dependent on client type.
“A focus and preference for liquidity has suppressed some of the appetite for hedge funds, which can have fewer liquid terms,” he adds.
Cooper says one trend he has observed is that investors who use hedge funds have increased their exposure to them. “In general, though, those that already have an allocation to hedge funds are generally more positive on the outlook for the segment, with the benefit of diversification as the main driver of this appetite,” Cooper says.
Although Claire Lincoln, global head of institutional investor relationships at the World Gold Council, says the economic picture is a big spur for investors to turn towards hedge funds. “With recession risk still on the table, further bumps in the road ahead cannot be ruled out and investors may look to increase hedging and/or defensive strategies,” she says.
Cooper adds that there are other reasons for investors to consider getting into hedge funds. “In addition to their potential to offer differentiated returns from traditional asset classes, hedge funds also have the potential to improve: one, risk/adjusted performance; and two, downside protection of a portfolio.”
The price of growth
Despite the attractions of hedge funds, the long shadow presented by high fees has frequently been a sticking point for investors. “High fee loads remain a challenge for certain investors,” Cooper says.
The fees issue reared its head in an Alternative Investment Management Association (AIMA) investor survey. The key point it revealed was that investors are increasingly making a high level of transparency around fees and expenses a pre-requisite to any allocation.
The report asserts that hedge fund managers and investors are continuing to explore more “equitable compensation arrangements which meet their expectations”. This potentially suggests a power shift in favour of investors, with more varied and better fee models being offered by many hedge funds to investors.
AIMA’s research also showed that North America had reclaimed the title of the most con dent region for hedge funds, having trailed the UK for seven consecutive quarters. The reshuffle reflects resilience among North American fund managers, AIMA says, and could be a useful guide for investors wanting to bring a hedge fund on board.
And investors have gone big on hedge funds – at least when measured by those funds reporting to Aurum’s Hedge Fund Data Engine – which have grown by $35.3bn (£28.4bn) since the end of 2022 to stand at $2.9trn (£2.3trn). This was driven by net positive performance of $79.4bn (£64.1bn), which was partially offset by net outflows of $44.1bn (£35.6bn).
Seven of the eight master hedge fund strategies saw growth in assets under management, led by multi-strategy funds and followed by equity long-short vehicles. Multi-strategy fund growth was driven primarily by positive performance and modest capital inflows.
Where to look
But while hedge funds could well offer something for institutional investors, given the vast nature of the hedge fund universe, where should institutional investors be looking? Investors often cite finding the right hedge fund, at least those unfamiliar with the hedge fund world, as something akin to finding a needle in a haystack.
“We continue to favour strategies such as global macro and CTAs [commodity trading advisers] as well as relative value strategies,” says Ghali, offering an insider’s guide. He cites these being attractive due to “their non-correlated profile” and the fact that they are able to provide protection in challenging markets such as last year.
“Should we end up in a sustained, long-term bull market, models should be also able to adapt to this,” he adds.
However, Ghali also notes: “We are cautiously positioned and as such want some protection in our portfolios as we think there are a lot of risks on the horizon.”
Although it should be noted that CTAs have had much publicised difficulties. To this, Ghali counters: “While 2023 has been challenging for some, but by no means all CTAs – we have some that are up 7% this year – we tend not to look at short-term performance but rather act like investors and not traders.”
And he adds: “It is hard to judge any strategy on a few months of returns. While short-term performance tends to be head turning, it often isn’t that informative.”
Ghali also discusses the type of strategies that interest him: “We also are looking for strategies that are cash efficient and hence can benefit from the tailwind of higher rates on their unencumbered cash positions.”
Cooper has an enthusiasm for global macro in his hedge fund wish-list. “Multi-manager platforms and global macro strategies have generally attracted inflows and have tended to perform strongly over the medium term,” he says.
However, Cooper adds: “Within these strategies there is a scarcity of supply of high-quality managers. Larger, more established funds, with good track records, are able to secure more favourable economics and terms.”
Global macro is attractive for several reasons. But the key one is if the trend toward what is often termed de-globalisation continues, there is a belief that individual economies will become less connected, and monetary and fiscal policies naturally will follow. This could lead to greater dispersion in the performance of asset classes globally – a hugely rewarding backdrop for global macro managers.
But the economic environment is changing. This potentially could see the environment move away from that attractive picture for hedge funds. After the high inflation experienced in 2022, is the case for macro hedge funds still intact?
“We believe so,” Meisan Lim says. “First, we suspect risks are skewed to either matching or exceeding current inflation expectations,” she says. “As a group, macro funds have a wide range of resources to identify mis-pricing and can choose from a variety of instruments to maximise their payout.”
Lim notes other tailwinds support the thesis that a macro strategy will do well in an environment susceptible to inflation surprises. “Rather than focusing on promoting maximum employment as it did in the low-inflation era, the Federal Reserve is now forced to favour combating inflation by raising the Fed funds rate,” she says.
Furthermore, Lim adds that when quantitative easing flushed the markets with liquidity and drove investors to reach for yields higher up the risk curve, concentrated beta-driven portfolios were more attractive than a diversified portfolio with many alpha sources. “Now that monetary tightening is in effect and interest rates have risen, macro managers are in an opportune position to benefit from greater alpha opportunities and diversification of assets and geographies,” she says.
So the message is clear: institutional investors should be looking towards hedge funds to help boost and diversify their portfolio.