Investors have responded to the ongoing volatility in the public markets by increasing their allocations to the expanding universe of alternative investment strategies.
Flows into private credit and private equity funds have gained significant momentum not just among major institutions but also from sophisticated wholesale investors who have looked to diversify their portfolios with assets not directly correlated to public equities or fixed income markets.
Although private credit and private equity have a long history of generating impressive returns, many of these funds have lacked a crucial feature that is highly valued by investors: liquidity.
Hedge funds represent another strategy within the alternatives universe, offering the potential for uncorrelated returns but with the added benefit of liquidity. Despite these advantages, investors have largely remained cautious, favouring other alternative investments over hedge funds.
The past decade has been tough for many hedge funds, leading to investor caution. However, performance is improving, and with the emergence of a new investment regime—characterised by higher volatility, inflation, and increased divergence across regions, sectors, and securities—hedge funds may now have a unique opportunity to thrive as traditional asset classes face new challenges.
Hedge fund managers have access to a broad toolkit, including shorting, leverage, and derivatives, allowing them to achieve a risk and return profile distinct from traditional assets. When used effectively, these strategies can make hedge funds a valuable addition to a diversified portfolio.
In low-growth or fragmented markets, hedge funds can also generate alpha through active management, capitalising on inefficiencies that are hard to access with traditional long-only investments.
Australia’s $200 billion Future Fund, for example, credited a “remarkably consistent” performance across its hedge fund portfolio as a key factor in delivering its overall 9.1% return for the 2023 financial year.
The Future Fund allocates to a wide range of hedge fund strategies, and chief investment officer Ben Samild said all had delivered “pretty strong, positive returns.”
“You can more easily build a well risk managed portfolio when you have more levers to pull, and we think that managers have more levers to pull and you can see that outcome in returns,” Samild said in a September 2024 interview.
The Future Fund, he said, had been building its portfolio of hedge funds for 15 years as it sought to build resilience to market volatility.
“When you increase the probability of a world with higher inflation and more macro volatility, you want to hold a different portfolio to make you more resilient to that environment,” Samild said.
“We think it’s very diversifying, its largely liquid, and it’s a very useful portfolio tool.”
Blackrock, the world’s largest asset manager, has published research** which shows that hedge funds particularly benefit from higher interest rate environments.
When cash rates are higher than 2%, for example, long short equity funds have historically delivered a median return of 13.6%, compared to only 5.6% when cash is at 0.5% or lower.
The median return for global macro funds has been even higher, at 15.6% when cash is at 2% or more.
For multi-strategy funds, the median return in a higher interest rate environment is as much as 9.2%.
While the US and other central banks are moving into an easing cycle, rates are generally travelling at well over 2% in developed economies, many of which slashed rates close to zero as part of their response to the Covid-19 pandemic.
Investor sentiment towards hedge funds has also become more positive. A 2024 survey of more than 300 investors representing more than US$7.5 trillion in assets under management by Barclay’s Capital Solutions team found that hedge funds and private credit are the most favoured alternative strategies.
Where 37% of the investors said they planned to increase their allocations to hedge funds, only 12% were planning a decrease. In addition, 85% of the investors planned to make at least one allocation to a hedge fund this year, compared with 80% in 2023. They were also looking to add new managers, with 95% of those planning to allocate to hedge funds saying they would allocate to a hedge fund not currently in their portfolio.
Those sentiments were also reflected in research by the Carne Group^, which interviewed over 200 alternative asset, equity and fixed income fund managers who collectively manage US$12.6 trillion across ten countries.
Renewable energy, private equity and hedge funds were the three asset classes which were expected to see the biggest growth, with 27% forecasting a “dramatic increase” in hedge fund allocations.
No two hedge funds are alike, as their strategies differ in terms of the assets they invest in and the risks they take on.
Manager selection plays a pivotal role in hedge fund investing because of the complex and varied approaches these funds use. A skilled manager can navigate market challenges and deliver strong returns, even during extreme volatility, while a less experienced manager may struggle, potentially resulting in significant losses. This makes it essential for investors to thoroughly evaluate each manager's expertise and focus.
Additionally, hedge funds tend to operate with less regulatory oversight and transparency than traditional investments, making due diligence even more critical. Investors should consider the manager’s strategy and risk management as well as their track record and reputation across different market conditions.
With ongoing market volatility and interest rate dynamics, the hedge fund sector could see tailwinds in the next cycle, offering investors a valuable option for uncorrelated and more liquid returns.
Our approach to helping investors build hedge fund portfolios has led to partnerships with three high quality hedge fund managers, each offering distinct strategies aimed at delivering diversified sources of risk and return.
The goal of hedge funds is to achieve positive returns regardless of the market environment. By including asset classes and strategies not found in traditional investments, hedge funds can potentially lower overall portfolio risk.
Hedge funds do not stand alone in investment portfolios, but exist to allow investors to target outcomes like reduced volatility, positive returns in any market environment, or higher potential gains.
As the Future Fund experience has shown they are not speculative investments. They deliver best over longer time periods, and like all investments can have good and bad years.
By allocating across the spectrum of alternative assets in both liquid and less liquid vehicles, advisers and investors may establish and maintain a comprehensive and strategic exposure to alternatives to complement traditional allocations.
While the macro environment continues to be volatile, investors who may have been wary of hedge funds might consider adding them to their portfolio as they look to build more resilience. Hedge funds can help fill gaps and meet goals when used correctly. With uncertainty around rates and policy, geopolitics, and global elections likely causing market shifts, now is a good time for active management. As equities and bonds may move together due to rate and inflation changes, hedge funds can provide valuable diversification.
*Source: Investor Strategy News, 4 September 2024. https://ioandc.com/really-delivered-hedge-funds-equities-boost-future-fund-return/
^Carne Group, Change 2024 Report, February 2024: https://www.carnegroup.com/latest-thinking/global-fund-managers-and-investors-are-optimistic-on-growth-despite-increased-expectation-of-market-volatility
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