The return of a fundamentals-based environment
The best environments for these actively managed strategies are markets that are driven by fundamentals, where there is real price discrimination between securities, companies and sectors, and reasonable volatility. Some strategies also tend to benefit from large dislocations.
In contrast, markets characterised by compressed volatility, central bank and government intervention, and persistently low interest rates, as was the case between 2008 and 2020, do not provide attractive opportunities for hedge funds. As a result, during this period, hedge fund strategies underperformed equities and returned no more than government bonds. They provided some diversification benefits, but the risk/reward ratio was relatively unattractive.
The industry has matured
These tougher times have allowed the industry to mature. Regulators set their sights on hedge funds in an effort to improve transparency and accountability. As a result, the rate of creation of unstable start-up funds with low assets under management has dropped due to increased regulation and operational and financial burdens. In addition, UCITS laws have made it easier for investors to expose their portfolios to hedge funds in a more liquid form than before.
A promising future ahead
Since the second half of 2021, the financial market landscape has changed abruptly as both equity and fixed-income markets have repriced due to higher inflation and rising interest rates. Initially cheap assets have gone back up while overpriced assets have fallen. The tightening of financial conditions with the end of quantitative easing, the return of volatility and the fear of a significant economic slowdown have restored the conditions under which markets can properly assess risk. Added to this is geopolitical instability and the long-term trend away from globalisation. In this new setting, the analysis of fundamentals is taking over to determine which companies will survive and which will not. The return of increased dispersion between winners and losers is creating a fertile hunting ground for more sophisticated strategies and is opening the door to promising times for hedge funds.