What is a hedge fund?
Hedge funds are not easy to define because they do not constitute an asset class “contrary to received wisdom”, according to Fredrik Langenskiöld, an alternative investments specialist at Union Bancaire Privée (UBP). The term “hedge fund” covers a range of investment strategies that can involve all asset classes. There are four broad types of hedge-fund strategy: “Long/short, i.e. buying undervalued stocks and shorting overvalued ones; relative value, which involves taking advantage of abnormal differentials in prices or rates; global macro, i.e. betting on major macroeconomic imbalances and their impact on markets, with a distinction between discretionary strategies based on economic analysis and systematic ones based on algorithms; and event-driven, where managers seek to profit from major corporate events such as an M&A transaction or a bankruptcy.”
Back in favour in 2022
Until the 2008 financial crisis, the various hedge-fund strategies generally outperformed balanced portfolios, i.e. those consisting of 60% equities and 40% bonds. “However, over the next decade, massive central-bank intervention pushed interest rates down almost to zero and caused equity markets to rise in unison,” continues Fredrik Langenskiöld, “and so hedge fund strategies underperformed balanced portfolios until the end of 2021. But with the return of inflation and central-bank monetary tightening, volatility has increased substantially. This is good news for alternative asset managers, and macro and relative-value strategies comfortably beat balanced portfolios last year. Long/short strategies performed less well because many funds in that category are highly sensitive to equity markets.”
Greater transparency and lower fees
The renewed popularity of hedge funds has also been supported by the efforts of fund sponsors to increase transparency, but also by regulatory developments. “More and more hedge funds are available as European-style UCITS, allowing people to invest in alternative strategies while also having daily or weekly liquidity,” adds the expert. “These funds are no longer the sole preserve of large investors, but can be bought and sold like traditional funds. Fees have also fallen considerably. Before the 2008 crisis, funds generally charged a 2% management fee and a 20% performance fee. However, these figures have fallen significantly, and the average new fund charges fees of around 1% and 10% respectively. The same is true of the additional layer of fees charged by fund-of-funds UCITS, which is now only around 0.75% as opposed to more than 1% pre-2008.”
Were last year’s hedge-fund returns a flash in the pan, or will they last? It all depends on economic developments, as Fredrik Langenskiöld explains: “We expect the current environment to last a while longer, but with falling inflation. Interest rates should therefore remain positive, so we can expect default rates to rise among the weakest companies. This means that care will be needed in sorting the good companies from the bad in the next few years. We still see global macro and relative value strategies adding the greatest value, as was the case in 2022. Although individual investors now have direct access to hedge funds, the large number of funds available may make it hard for them to choose. For that kind of investor, funds of hedge funds – which provide diversified exposure – could be a more sensible choice,” he concludes.