Future Returns: Turning to Hedge Funds in Today's Market Uncertainty

Future Returns: Turning to Hedge Funds in Today’s Market Uncertainty

Amid equity and bond market volatility this year, hedge funds have largely served as a buffer for investors, and some private wealth managers expect these alternative investment vehicles to continue to deliver results over the the year to come.

Although aggregate hedge fund returns fell 9.3% this year in the third quarter, large-cap US stocks fell nearly 24% over the same period and long-term US Treasuries fell. dropped nearly 30%, according to Sam Monfared, vice president, Research Insights. , at Preqin, a London-based company that provides alternative investment data and analysis.

Specifically, some hedge fund strategies actually posted positive returns. Commodity Trading Advisors, or CTA hedge funds – which mitigate risk through the use of futures and derivatives – generated a return of 8.2% in the third quarter, while macro funds generated a return of 4.5% and relative value funds generated a return of 0.2%, according to Monfared.

“It’s a pretty impressive overall performance,” he said. “Categories designed to absorb market shocks were able to perform as expected. This is the reason why serious beneficiaries remain interested in hedge funds.

Hedge funds, which held about $4.3 trillion in assets globally at the end of the third quarter, according to Preqin, are one of the more mature parts of the alternatives industry, Monfared said. They use a range of actively managed strategies in public asset classes, including currencies (FX) and commodities in addition to stocks and bonds, and they use techniques, such as leverage or derivatives, to obtain higher returns.

They are also not for the average investor. Hedge funds are generally riskier than traditional investment vehicles and cannot be abandoned quickly. Additionally, most hedge fund companies charge a 2% management fee and a performance fee of 20% of profits, and they typically require high minimum investments of at least US$1 million. .

The story is different for wealthy investors. In fact, among hedge fund managers recently surveyed by Preqin, nearly 48% said they had seen an increase in assets from private wealth management firms, while nearly 45% saw no change. These results “show that people continue to allocate where they see value,” Monfared says. “If you’re serious about risk management, you want to include hedge funds in your portfolio.”

At UBS Global Wealth Management, Karim Cherif, head of alternative investments in the chief investment office, says a risk-balanced portfolio should have an allocation of around 11% to hedge funds. “Uncorrelated” hedge fund strategies, meaning those designed not to move at the same pace as the markets, are among the firm’s recommended moves for next year.

penta recently spoke with Cherif about why these vehicles are worth a look and strategies to consider.

Why invest in hedge funds now?

While hedge funds have generally proven to be a solid investment — yielding nearly 7% more than cash per year since 1990, according to UBS — they may continue to be welcome today, especially for U.S. investors.

Indeed, rates continue to rise and inflation continues to reach record highs, a rare phenomenon that causes stocks and bonds to underperform. Moving more or less in sync, instead of diverging as usual, investors suffered “portfolio losses that we haven’t seen in a while,” says Cherif.

“In this environment, investors have very few options for increasing the diversification of their portfolios,” he says. “Hedge funds are part of the solution given their ability to generate returns that are less correlated to market movements.”

Although rate trends and the economic environment will differ from country to country and region to region, UBS expects that, even globally, the volatile business environment current situation is not abating, which means it makes sense for global investors to consider hedge fund strategies. to protect against downside swings, says Cherif.

Hedge funds also allow investors to play offense, he says. While volatility rocks all asset classes, from FX to credit, within asset classes there are sectors that are doing well while others are not, a characteristic of the market known as the name scatter.

Within stocks, for example, energy and healthcare stocks have performed relatively well compared to growth stocks, such as technology. In credit, long-term bonds underperformed short-term or variable-rate securities, Cherif said.

“We had a long period where putting a trade on just about anything would end up being rewarding most of the time,” he says. “This is an environment where pricing risk matters more. Because of this, you have this dispersion coming back into the market. This is what hedge funds need.

Choose the right strategy

According to Monfared, specific hedge fund strategies that have performed well so far this year should continue to perform well in the first quarter of next year, given market dislocations and high volatility, factors that benefit hedge funds, although he cautions that there is no way to know for sure how 2023 will play out.

One important factor is a divergence in central bank policies. The Bank of Japan, for example, barely raised rates, while China continued to lower them and the US Federal Reserve raised them sharply.

It’s an environment that has been perfect for CTA funds, and Monfared expects it to continue. Cherif warns, however, that the algorithms behind CTA strategies tend to work best when the markets are directional.

“If you’re in a market that’s trending up, then you’d be long that market, and if the market is trending down, you’d sell it,” says Cherif.

Although CTA strategies work well now, they often miss the moment when a market turns around because the patterns are based on historical data, he says.

Instead, UBS currently favors macro funds – which have similar characteristics to CTA funds but without the algorithms – in addition to equity-neutral and multi-strategy funds. Overall, the firm recommended investors “balance strategies and styles to diversify sources of return, maximize the chance of positive performance, and reduce the potential impact of one or a few drivers.” .

Macro strategies aim to capture macroeconomic shifts and imbalances in the economy, drawing from a wide range of asset classes, usually easily tradeable securities or currencies.

“Historically, these funds have had a low correlation to large market movements, and they have been able to, for example, take advantage of changes in monetary policy, high inflation, [and] higher volatility,” says Cherif.

According to UBS’ November hedge fund industry report, equity market neutral strategies use so-called long-short strategies to buy stocks they expect to outperform and short stocks they expect to outperform. underperform. This approach allows investors to earn above-market returns and can get away with when there is high dispersion within stocks, as there is today.

UBS also likes multi-strategy funds that can take advantage of the best opportunities in each hedge fund strategy. “It’s a solution that allows you to invest capital where the most attractive risk/reward ratio is and adapt to changing economic conditions,” says Cherif.

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