The basic concept of a hedge fund strategy is to buy undervalued assets and sell short those regarded as overpriced. The aim is to take advantage of differences in the assets’ performance, and this dispersion is a driver of returns for all types of alternative strategies. The hedge fund industry entered a difficult phase in 2009 because dispersion stopped moving in the right direction.
However, 2022 was a turning point and a new situation is now in place, since central banks are having to revert to their primary mission of ensuring price stability. This has created a great deal of turbulence in financial markets, made worse by the conflict in Ukraine. Even before the spike in energy prices caused by the war, the US economy was showing signs of overheating, and rate hikes were therefore necessary to curb inflation.
Hedge funds once again find themselves in a situation where the market is evaluating risk more rationally, and they are benefiting from increasing demand for decorrelated strategies.
However, not all hedge funds are the same! Although there are some attractive opportunities, investors must pay attention to the fund’s strategy, and above all its style. Since long/short equity funds make up half of the industry, it is important to be selective. In current market conditions, funds that are highly exposed to equities will continue to be severely tested. However, there are several categories of specialist managers that should be able to generate attractive returns.
The outlook for alternative investments remains positive for 2023, because of higher interest rates – at least for the time being – but also ongoing volatility and a general sense of uncertainty in all markets, i.e. equity, fixed-income and foreign-exchange. Another important factor is that these conditions are likely to result in greater dispersion between winners and losers, creating fertile ground for many alternative strategies such as quantitative and global macro. In both of those cases, uncertainties relating to inflation and the risk of recession are giving rise to trading opportunities as market sentiment moves quickly from panic to denial. These strategies generally benefit more from the volatility that results. China’s recent reopening should also be an interesting theme that gives rise to new opportunities: alternative managers will be able to take advantage of the situation, particularly the inflow of money into the region after around three years of inactivity.
In terms of long/short equity strategies, high dispersion will be the main driver of returns. Overall, the outlook in terms of corporate earnings and stock market returns in 2023 is not good. We can expect fundamentals to regain the upper hand in determining share prices, and they should be the focus of analysis. Companies with solid balance sheets will see their fundamentals affected much less than those of more fragile firms. In those circumstances, strategies with limited sensitivity to equities will be very attractive.
As regards credit, the current environment means that certain overindebted companies will not be able to cope with the higher cost of the debt they have built up since the pandemic started in 2020. This will prompt restructuring, leading to a raft of opportunities for credit-focused asset managers and the possibility of capturing higher interest income.
The alternative investment industry has also seen a major structural shift, with a growing number of multi-manager platforms. Although each has its specific attributes, a clear distinguishing feature is their ability to attract the best experts. In recent years, the pace of new fund launches has slowed considerably because managers have been recruited by these hedge fund platforms, which have a business model that is attractive to managers, while ensuring a firm grip on risk. And the results can clearly be seen: in the last three turbulent years, the largest platforms have performed very well overall, with positive double-digit returns and limited volatility.
The alternative asset management industry is now mature, and the best alternative managers have proven that the key to success lies primarily in strict risk management, but also constant investment in talent and innovation.
In the current context, it makes a lot of sense for investors to allocate some money to a basket of hedge funds that are diversified in terms of strategy and style, which will ideally complement their exposure to equities and bonds.