Over a 12-month period, hedge funds have delivered decent returns while global financial markets became increasingly volatile.
However, several factors — such as rising US interest rates, the recurrence of big fluctuations in global currencies, and the widening dispersion of equity returns across sectors and regions — appear to be creating a conducive environment for hedge fund strategies.
Over a 12-month period (ended June 30), global hedge funds – as measured by the HFRX Global Hedge Fund Index – delivered decent gains of 6% in US dollar terms. (1) That’s a vast improvement in the performance of these alternative investments from the prior two years. Year-to-date, the HFRX Global Hedge Fund Index was up more than 2.56% in US dollar terms (year-to-date through May 26 2017).
Rising rates a boon for hedge funds
After hovering near zero for seven years, US interest rates started moving higher in late 2015. At the same time, we’ve observed a turnaround in hedge fund strategy performance (since early 2016).
This trend helped skillful hedge fund managers to tap their quest for alpha, which we define as a risk-adjusted measure of the value that an active portfolio manager adds to or subtracts from a portfolio’s return.
Statistical analysis of the historical relationship between interest rates and alpha supports the notion that hedge funds generally do better in a rising-rate environment. The logic is straightforward: when interest rates are rising, there will be wider dispersion of returns across different asset classes, thus creating more trading opportunities for the alpha-capturing hedge fund managers.
Alpha can be more pronounced and stronger during specific economic cycles or investment milieus, such as periods with higher interest rates. It can be weaker and insipid in other phases.
The chart below highlights the positive correlation between alpha levels (relative to the S&P 500 Index) on the Hedge Fund Research Index Fund Weighted Composite Index (HFRI FWI) (2) and interest rates, as measured by the five-year US Treasury yields, over a 26-year period from January 1991 through April 2017.
It shows that higher nominal interest rates historically corresponded with above-average annual alpha for the HFRI FWI. For instance, when rates moved to their highest level (represented by the fifth quintile bar on the right side of the graph), average alpha levels similarly surged to the uppermost level.
More opportunities for certain hedge strategies
In the equity space, when interest rates move higher, companies with weak fundamentals could face mounting pressure as they may be limited in their ability to take advantage of lower interest rates to finance their business operations. Debt-laden firms could also experience additional financial stress as borrowing costs mount when interest rates start to climb. On the other hand, a rising-rate environment could benefit cash-rich companies, whose financial statements will potentially look better as a function of interest income earned from their cash surplus.
The deterioration in operational performance, profit margins and financial strength of weaker listed companies could weigh down their stock prices when interest rates are moving higher. Meanwhile, shares of fundamentally solid companies with excess cash could get rerated on the back of higher interest income.
Theoretically, there will then be greater price dispersion between the stocks of weaker companies and those that are fundamentally stronger when interest rates trend higher. This could create trading opportunities for long short equity managers, which may have a more well-defined universe of stocks, in terms of potential winners and losers.
In the fixed-income arena, longer-duration bonds (duration is a measurement of a bond’s sensitivity to interest-rate movements) tend to be more negatively impacted when interest rates move higher as compared with shorter-duration fixed income securities. Indeed, the downturn in the US government-bond market at the end of 2016 and earlier this year benefited many fixed income managers who were able to take advantage of the price decline in US Treasuries during those periods.
Better environment to capture potential alpha
Hedge fund strategies generally didn’t do well in 2014 and 2015 — a period when the erratic “risk-on” and “risk-off” trading patterns were prevalent in global financial markets.
In our view, that difficult period for hedge fund strategies now appears to be over. Of late, global investors have become more discerning in their investment selection and asset allocation processes, with more emphasis on fundamental factors.
Event-driven and long short equity managers, for instance, have overall seen rosier average gains over the past 12 to 18 months on the back of investors’ growing focus on company-specific events, earnings growth, balance sheets and valuations of individual securities across different sectors and regions.
At the same time, investors who may be unsure about the prospects of equities and bonds seem to be starting to allocate more money to hedge fund strategies that aim to capture alpha in both up and down markets. All in all, we think the current market conditions look conducive for a variety of hedge fund strategies.
Brooks Ritchey is K2 Advisors’ senior managing director.
1. The HFRI Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe reporting to Hedge Fund Research Inc. database. Indexes are unmanaged and one cannot directly invest in them. Unlike most asset class indexes, HFR Index returns reflect fees and expenses. Past performance is not an indicator or guarantee of future performance.
2. Alpha calculated relative to the S&P 500 Index. The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2 000 single-manager funds that report to Hedge Fund Research Inc. database. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Unlike most asset class indexes, HFR Index returns reflect fees and expenses. Past performance is not an indicator or guarantee or future performance.
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