The Hedge Fund Comeback
To the surprise of some investors, hedge funds have experienced a revival over the last year. Financial markets have been dealt with shocks from the global pandemic and majors shifts in government policies, but overall hedge fund strategies have performed relatively well. The Credit Suisse Hedge Fund Index that tracks the performance of a broad range of hedge funds has posted strong returns over the last twelve months ended July 31st, with positive returns for all nine sub-strategy categories.
Rising capital inflows into hedge funds
The positive showing has helped reverse the net outflow of capital from hedge fund strategies experienced for most of 2020, with a recent report from Barclays showing rising capital inflows across a range of different strategies in the first half of 2021.
Stronger returns have perhaps changed investors’ mindset
While we’ve witnessed high-net worth investors allocate a growing share of their portfolios to alternative strategies including hedge funds, private equity, and real estate over the last decade, hedge funds have come under greater scrutiny due to lacklustre returns. The combination of intense competition within the industry and an extended period with strong equity and bond returns, drove some investors to question the value proposition for hedge funds within their portfolios. The stronger investment returns have perhaps changed investors’ mindset as we note that 38% of investors intend to increase their allocation to hedge funds in the coming year according to the latest Blackrock Global Family Office Survey.
Renewed interest in hedge funds
We attribute some the renewed interest for hedge funds to the strength in market returns. Virtually all asset classes have experienced a material increase in value, with equity markets front and center as the MSCI World Index generated a 36% return over the year ended July 31st. While future market returns are subject to change, we still believe hedge fund strategies should play a role in investment portfolios. Hedge fund strategies can generate attractive returns relative to traditional asset classes by capturing market price dislocations, effectively using financial leverage to augment returns and practicing sound risk management. In addition, hedge funds also offer superior liquidity characteristics relative to alternative strategies such as real estate, private equity, and venture capital.
What does the future look like for hedge funds?
Although we are unlikely to witness hedge funds deliver stellar returns like many achieved in the 1990s, the current market environment may allow these strategies to stand out over the next decade. First, we have witnessed a massive surge in new capital raised from debt offerings, initial public offerings, and special purpose acquisition companies (SPAC). There has also been growing capital flowing into digital currencies and non fungible tokens that is gaining prominence. Most of this capital has been raised during a period with a tremendous level of liquidity and with investors readily accepting shrinking risk premiums. In the coming years we will undoubtedly encounter periods of weaker economic growth and rising risk premiums that will create greater price volatility for many of these assets. We believe that this is a fertile environment for multi-strategy funds that can capture arbitrage opportunities across a spectrum of asset classes as price volatility will rise for newly formed assets.
Response from policymakers
There has been unprecedented response from policymakers with numerous programs initiated to stimulate the global economy due to the pandemic. The short-term impact has been positive with broad gains across regions and asset classes. However, the longer-term effects of these measures and the recovering global economy will likely see a dispersion in returns. There is the potential for regime shifts depending on how governments and policymakers react to rising inflation, social inequality, and geopolitical disputes. This provides investment opportunities for global macro strategies to capture attractive returns in different regions and across asset classes.
Are hedge funds a fit for your portfolio?
While we are constructive in assigning a portion of a client’s portfolio to hedge fund strategies, we recognize that the investment risks associated with these strategies may not be tolerated by some investors. As investment counsellors the first order is to establish that our clients have the risk capacity and tolerance to invest in hedge funds. Hedge funds undertake financial leverage by borrowing and in using derivative products to augment returns. Some strategies are also dependent on illiquid investments or take concentrated positions in securities that raise idiosyncratic risks. In addition, most hedge funds have lock-up features that restrict an investor from withdrawing money or exiting a fund for a period of time.
Due diligence
Our investment committee undertakes a thorough due diligence process to identify, analyze and approve hedge fund strategies we want to include in client portfolios. Although the review takes into consideration a number of variables, we look for investment strategies that have track record of generating returns in a variety of market cycles. We also ensure that investment processes are complemented with independent and robust risk management framework that can restrain strategies from taking unjustified risks. It also important that there is strong alignment, and the investment managers have a material amount of their net worth invested in the fund strategies. This includes the committed capital to building the infrastructure to support the investment strategy via technology systems and talented personnel. Contact us if you would like to learn more about hedge funds.
