Hedge fund opportunities

The tide is turning for hedge funds

There’s a new regime in financial markets and that means conditions are also shifting in the hedge fund landscape.

Interest rates have risen at the fastest pace in recent memory from the ultra-low levels experienced for much of the last 15 years. We believe higher rates bode well for hedge funds going forward. Rising rates should not only translate to higher baseline returns for many hedge fund strategies but also create more opportunities for hedge fund managers, given their natural role as liquidity providers and opportunistic investors.

Quantitative easing suppressed volatility for years, making it difficult for strategies seeking to provide liquidity and opportunistically price risk. But we now see quantitative tightening bringing those opportunities to the forefront again, while upending risk/return expectations across asset classes.

With our decades of experience investing in hedge funds, we see two key factors leading to an improved outlook for hedge funds: higher risk-free rates and greater absolute return spreads.

Hedge funds have performed better in higher risk-free rate environments

Embracing elevated uncertainty

Broadly, we believe hedge funds remain well-positioned to adapt to a shifting and increasingly uncertain economic outlook.

These strategies have reaffirmed over recent years that they can be truly uncorrelated and play a critical role in a whole-portfolio context. In addition to rising rates, we expect uncertainty around persistent inflation, tighter credit conditions, and the specter of recessions to be driving forces behind near- to medium-term market moves.

For example, in an era of tightening financial conditions, economic damage has the potential to manifest rapidly in unanticipated market segments. Financial cracks from the fastest rate hiking cycle in decades have already emerged in the banking sector, impacting the supply of credit.

While these conditions can present challenges for buy-and-hold strategies, they often create opportunities for hedge funds that utilize more agile, tactical, and diversified approaches to investing.

Highest dispersion in decades

We believe in the current environment, investors that are less constrained and able to pivot quickly will be rewarded. In this new regime, we should continue to expect a wider range of possibilities. Portfolio construction and implementation will be critical.

But choosing the right mix of hedge funds remains key. There continues to be a significant degree of return dispersion across hedge funds: the top decile of the HFRI Fund Weighted Composite Index gained 39% on average in 2022, while the bottom decile fell 33% on average. That’s the widest performance gap since 2008¹. This wide range of fund performance underscores the importance of an experienced and well-equipped team capable of sourcing the most skilled and resourceful managers.

Source: HFRI Indices December 2022 Performance Notes, ©HFR, Inc., 9 January 2023