Rethinking portfolios requires new approaches to navigate a shifting and uncertain economic outlook. We review some of the hedge fund strategies that can potentially tackle the challenges investors face today.
Unlike most other types of investments, hedge funds thrive on volatility and uncertainty in traditional markets. Offering strategies proven to be uncorrelated, hedge funds have historically performed well in high interest rate environments given the potential for higher baseline returns and a widening alpha spread. Similarly, given their investment flexibility to hold long and short exposures, hedge funds are often effective when markets get distorted and mispriced due to factors such as geopolitical tension or economic woes.
Past performance does not guarantee or indicate future results Source: Morningstar as of 30 June 2023. Median index return since 1 January 1994. Hedge Funds are represented by the Credit Suisse Hedge Fund Index, Event Driven by the Credit Suisse Event Driven Index, Long/Short Equity by the Credit Suisse Long/Short Equity Index, Global Macro by the Credit Suisse Global Macro Index, and Multi-Strategy by the Credit Suisse Multi Strategy Index. Index performance is for illustrative purposes only and is not meant to represent the past or future performance of any particular BlackRock fund. Indexes are managed and it is not possible to invest directly in an index.
Well-suited to a new investment era
We see three key factors that bode well for hedge funds.
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Higher-for-longer rates outlook
Firstly, the market has come to accept a higher-for-longer rates outlook. While major central banks are at – or at least near – the peak of their tightening cycles, rate cuts are unlikely in developed markets until later in 2024. While “holding tight” to lean into inflationary pressures is not a friendly backdrop for broad asset class returns, the scope for hedge funds to structurally benefit has increased. Hedge fund returns are higher when interest rates are higher.
Nimble and dynamic investing
Another trend conducive to hedge funds is the need for investors to pivot to new opportunities by being nimbler and more dynamic. This is a consequence of greater uncertainty resulting in divergent security performance relative to the broader market. In turn, investors are seeking ways to build portfolio breadth via uncorrelated exposures, requiring the kind of deeper, more granular and increasingly tactical approach typically the forte of hedge funds.
Given their uncorrelated nature and focus on idiosyncratic risk, the addition of hedge fund exposure to a portfolio can improve diversification – in turn leading to a more robust portfolio over a market cycle.
Traditional + Hedge Funds portfolio allocation: 20% Hedge Funds, 35% Fixed Income and 45% Equity
Traditional portfolio allocation: 40% Fixed Income and 60% Equity
Source: eVestment: Equity: MSCI AC World Index; Fixed Income: Bloomberg Barclays Global Aggregate Index; Hedge Funds: Q-BLK Appreciation Composite (“QAC (net)”). Data is for time period: 1 August 1995 – 31 December 2023. Indices have no fees, are unmanaged, and are used for illustrative purposes only. Indices are not intended to be indicative of any fund’s performance. It is not possible to invest directly in an index. Diversification may not protect against market risk or investment loss. Past performance is not an indication of future results. The definitions and disclosures appearing at the end of this document are an integral part of this presentation and should be read in their entirety for a complete understanding of the information contained herein.
Capitalizing on mega forces
Thirdly, hedge funds can capitalize on mega forces like climate change and technological breakthroughs that are reshaping global economies, and already playing out today. As a result, the ability to remain flexible and identify the catalysts that can supercharge them calls for granularity in the sectors and companies set to deliver durable returns across cycles.
Strategies to tackle today’s market regime
Hedge funds can serve multiple purposes for investors at any time, some of which are especially appealing at the moment. These include:
- Delivering independent return streams to make a broader portfolio more resilient
- Outperforming when equities and bonds decline – to help mitigate downside risks
- Improving returns for the same amount of risk taken
Disclaimer: Diversification does not assure a profit and may not protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.
While allocation preferences should be driven by an individual investor’s portfolio objective, specific hedge fund strategies are well suited to today’s current conditions.
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Higher rates and tighter financial conditions The impacts of higher rates and tighter financial conditions have been widely felt – from weakness in the banking sector in the earlier part of 2023 , additional pressure on already-stressed commercial real estate, lower levels of mortgage affordability, to the general poorer financial health of consumers. Further, amid higher rates, there is less willingness to roll over maturities to companies that don’t generate sufficient cash, increasing the risk of more defaults. These conditions give credit strategies a tailwind. For example, the potential for more restructurings may create a greater need for capital solutions and could enhance the prospects for distressed debt and opportunistic-lending funds. These strategies can offer investors a way to generate returns through both alpha and carry while mitigating downside through capital structure positioning. |
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Uncertain macro fundamentals Amid an environment of greater return dispersion, equity-and credit-focused funds that offer fundamental long/short strategies should be in favour. This marks a clear departure from the previous regime when rates were anchored near zero, limiting the possibility of meaningful risk taking and also suppressing shorting. Now, however, as competition for capital increases, and lower-quality businesses that were reliant on cheap financing under pressure, more focused analysis via a robust, data-driven macroeconomic research process is essential. The key is to identify the more diverse set of winners and losers by uncovering under-and over-valued companies, along with the range of pricing inefficiencies from supply/demand imbalances and market segmentation to divergent monetary and fiscal policies, and mispriced economic and political risk. |
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Fluctuating and volatile equity markets Greater levels of volatility have resulted in securities performing differently to how they have in the past, requiring investors to look deeper into industries and companies to find compelling returns. Yet at the same time data from central banks and other economic and market indicators are being over-analyzed and amplified. These trends and dispersion between winners and losers have sharpened the spotlight on security selection. As a result, the opportunity set for quantitative equity strategies has grown. By leveraging alternative and big data capabilities coupled with artificial intelligence, we uncover distinctive, company and market-specific insights. Through this approach investors can target a consistent alpha stream that is diversified across geographies, market capitalizations and investment horizons while uncorrelated to the broader equity markets. |
A new dawn with a place for hedge funds
The array of micro and macro dynamics at play today makes thoughtful allocation essential.
For investors seeking more precision in outcomes and well-rounded portfolios, the current environment creates an appealing backdrop for hedge funds – which offer a flexible investment mandate and dynamic approach to markets.
Steve Margitan
Product Strategy, Multi-Alternatives, Multi-Asset Strategies & Solutions
Carol Teng
BlackRock Alternative Specialists
