These are the days that people write books about. Indeed, following Covid and the impact of Russia’s invasion of Ukraine on natural resources, volatility is sweeping through the global investment markets, while traditional strategies, such as 60/40, are failing to protect investors. Yet hedge funds appear positioned to fulfil a need for institutional investors in an environment of raging inflation and rising interest rates.
Tom Kehoe, global head of research and communications at the Alternative Investment Management Association (AIMA), says this is very much in evidence, with hedge funds placing themselves in the shop window for investor attention. “Amid increasing turbulence across financial markets, hedge funds are reasserting their value proposition among investors who crave capital preservation and portfolio diversification,” he says.
So where should investors look within the hedge fund world, given the alternatives universe is a gamut of approaches? Two specific hedge fund styles stand out for investors to exploit. Discretionary global macro-focused hedge funds look a good bet given that macro policy is likely to remain a key factor driving markets. Relative value also looks a good prospect given that volatility is presenting a more attractive trading environment for active and relative value trading strategies.
“We like both of these strategies, they make a lot of sense in the current environment,” says Patrick Ghali, co-founder of Sussex Partners, an alternative investment adviser. “And the opportunity set should remain rich for the time being,” he adds.
Tailwinds
Expanding on these themes, Ghali highlights the all-important D word – diversification – benefit of investing in hedge funds. “It continues to make sense to invest in diversifying strategies such as global macro, quant/commodity trading adviser (CTA), equity market neutral and relative value strategies in the current environment, rather than to take market beta risk at this stage of the cycle.”
Looking at the two identified strategies, Kier Boley, chief investment officer of alternative investment at Union Bancaire Privée, agrees that discretionary global macro offers real benefits to investors. “Performance of discretionary macro managers continues to be on a positive trend that expected returns should be set at the top end of long-term trends,” he says.
A number of self-evident tailwinds support the strategy: higher front-end rates, central bank policy determined by economic fundamentals, commodity pricing set by supply-side constraints, higher levels of volatility across asset classes and deflating equity markets. “Over the near term, we expect some retracement in strong recent gains, as a number of markets are oversold and so prone for a technical bounce,” Boley adds, but it should “provide a good entry point for investors who have been underweight the strategy”.
A challenging environment
Although for some institutional investors, management fees are one stumbling block. With strategies such as discretionary macro being actively run, they tend to come with a higher price tag. But fees should be compared to the potential return benefits when assessing such strategies. As higher fees should be set against a backdrop of shifting relative net returns.
With traditional assets such as equities and bonds reverting to their lower long-term averages, discretionary macro continues to maintain its higher return profile. To back up this point, Boley says investors should benefit from returns ranging from more than 10% to 30% for discretionary global macro. Numbers that should make investors sit up and take notice.
However, the Eurekahedge Macro Hedge Fund Index, which tracks 238 constituent funds, showed an annualised return of 7.78% by October 2022. In addition, some of the fees are offset by the nature of discretionary macro investing, Boley says, which sits on large amounts of portfolio cash, as they tend to express thematic views through options and futures.
Boley also shares his enthusiasm for relative value with managers set to perform in line with long-term averages in 2022. But he highlights that it is an interesting picture. “On the one hand, increased equity market volatility is welcome, as it creates more opportunities to trade, more dispersion and shorter timeframes for trades to work – meaning portfolios can be reloaded more frequently,” he says.
But, he adds a warning: “On the other hand, increasing interest rates, steepening yield curves and tapering of quantitative easing (QE) programs could cause spreads to widen in credit. So less directional approaches are recommended.”
This opens up other hedge fund opportunity possibilities for investors. Boley sees convertible arbitrage, corporate credit trading strategies, versus long biased ‘coupon collecting’ type strategies and multi-strategy relative value approaches as reliable areas to add risk. “Over 2020 to 2022, and 2010 to 2013, fixed income relative value managers focused on micro dislocations in government bonds and related instruments found extreme quantitative easing and low rates a challenging environment,” he says.
However, he adds: “As rate volatility increased and quantitative tightening begins across geographies, we have seen real improvement in the trading environment, and this is reflected in performance year to date.”
Quant makes sense
There are other styles that could entice investors to make the hedge fund leap. “Diversified baskets of CTAs also make sense in the current environment,” Ghali says. “Quant strategies often make sense during periods of paradigm shifts as they remove the human element, and a basket removes some of the idiosyncratic manager risk and produces a more predictable, steady return stream.”
In addition, Ghali argues that the current market environment should favour the active management style of hedge funds. “Active management seems to be better suited to the current conditions than passive investments,” he says, adding: “We would avoid higher net exposure to equity managers as well as credit managers as this point.” And Ghali notes the key component parts that should be central to investor thinking towards hedge funds: “Manager and strategy selection remain key.”
A bad year?
Although, from a performance perspective, hedge fund investor sceptics could cite some poor results. The Barclay Hedge Fund index for the first half of 2022 reported average returns of -9.6%, with the average hedge fund down between 4% and 6%, for the year.
Yet in comparison, a 60/40 portfolio has lost nearly 20%, year to date, the same as the S&P500’s decline in the opening six months of the year, which, like much else in the financial world at the moment, is the benchmark’s worst performance since 1970. Indices do not present a true picture, Ghali says.
“It is somewhat facile to simply look at the overall index and determine that, based on this, hedge funds have not done well,” he says. “There are plenty of strategies other than equity long/short [which make up most of the index] that are doing well. “The focus should be on alpha strategies and not hidden beta, which can be accessed more cheaply and with better liquidity elsewhere.”
Ghali explains that in this context he has been avoiding higher net equity managers for quite some time. “A well curated portfolio of funds will be up in the mid-single digits this year, and some CTAs and macro managers have done a lot better than that. So, I do not agree with the notion that hedge funds have
had a bad year.”
Stable portfolios
On the contrary, hedge funds have played an important role in 2022, Ghali says. “Hedge funds have been providing much needed stability in portfolios this year,” he adds. Indeed, endowments, foundations and sovereign wealth funds have held their own this year, in part, due to holding a higher allocation to hedge funds compared to other institutional investors, according to Bfinance.
Here the style of a hedge fund is important, which again returns to the all-important D word. “If you were invested in diversifying strategies, you have had a good year so far,” Ghali says. “The issue is that too many investors equate the industry with long/short equity managers as they make up the lion share of the assets.” Strategies and manager selection were key to success this year, Ghali argues. Managers that rode the cheap liquidity wave have obviously suffered and investors are asking themselves if gains in prior years may have been due to beta rather than alpha. Our focus remains on alpha strategies.”
Regulatory headwinds
Some hedge funds face challenges on other fronts, specifically from regulatory demands – which is something of a recurring theme – and could shape the industry in different and potentially unknown ways. “Headwinds remain in the form of new regulatory and compliance demand, particularly coming out of the US as well as higher inflation levels and interest rate tightening, likely to impede on a firm’s ability to manage their business,” AIMA’s Kehoe says.
The US in particular has witnessed an unprecedented number of new industry proposals, which, if enacted, would make managing businesses extremely challenging and expensive for some funds. Indeed, not a week seems to go by without another proposal being put forward by the US Securities & Exchange Commission, in what amounts to a radical overhaul of existing market practices for the private funds industry.
European and Asia Pacific hedge fund managers are also having to consider a raft of new regulation being discussed which would impact how they manage their business. It could, though, be argued that the impact of regulation on hedge funds is overstated – or that its impact is more nuanced.
“Regulation is ever changing and that is nothing new for the industry,” Ghali says. “It tends to mean that smaller funds struggle more with the regulatory burden, and it means that the minimum assets under management to start a fund tends to creep up over time,” Ghali adds. “In that sense it may hinder talented smaller managers from taking the leap. But generally, funds are able to adapt.”
It is clear that hedge funds are part of a growing environment propelled by potential investor interest. And the ongoing bear market beset by geopolitical and macro-economic turbulence means that capital preservation and outperformance are top priorities for investors. This is reflected in AIMA’s study of how hedge funds feel about the future.
According to the AIMA Hedge Fund Confidence Index, the average measure of confidence in the economic prospects of their business in the coming 12 months is +25.4 – the highest score reported by hedge funds since this index began two years ago. Firms that demonstrated the highest levels of confidence were EMEA-based fund managers, with those in the Middle East reporting an average score of +31, almost eight points higher than the average reported by North American-based funds.
The focus on the Middle East is no flash in the pan, as it appears to be part of a wider trend. “Over the past 12 to 18 months, we have seen an increasing inflow of managers setting up in financial centres such as the Dubai International Financial Centre, to support their marketing efforts and to attract and retain portfolio manager talent relocating from the US, Europe and Asia,” says Muneer Khan, Middle East partner at law firm Simmons & Simmons.
Sovereign influence
Khan has been a keen observer in the tracking of investor capital. “The high scores for the [Middle East] are possibly due to increased oil and gas revenues, as well as more focused government economic diversification efforts, leading to managers attracting more assets under management from sovereign and
sovereign-related investors in the region,” he says.
Such a trend should potentially make investors sit up and take notice. It has led to some commentators dubbing the Middle East, and Dubai in particular, as the new hedge fund hotspot. Light regulation in the region, or lighter than elsewhere, may well be a contributing factor.
It all adds up to a reasonably upbeat situation for hedge funds: one that could well offer an array of opportunities to investors, if they seek to take what is on offer. A key part of that attraction is again the D word. “We expect positive sentiment for certain hedge fund sectors as investors consider their long-term strategic diversification,” a global survey of asset owners published by Bfinance concluded.
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