Despite high inflation and rising interest rates, it’s important to remember that even with the Fed’s hiking cycle interest rates are still relatively low. In addition, even though equity market selloffs have been common, equity multiples are still relatively high.
It has been a (very) long time since the Fed raised rates absent an above-average growth backdrop. When rates rise but growth is strong, equities tend to do well. But right now, growth isn’t strong, and rates are rising in a bid to tame inflation. While these conditions threaten traditional portfolios, they may create opportunities for hedge fund investors seeking to fill the gaps.
“Current market dynamics make it hard for traditional 60/40 portfolios to generate returns, leaving investors searching for alternatives,” says Darren Wolf, Global Head of Investments, Alternative Investment Strategies, abrdn. “As an asset class, hedge funds have historically done well in challenging market environments similar to the one we’re in right now.”
The case for hedge funds
Hedge funds could be a compelling answer to today’s uncertain markets chiefly because they’re so flexible. Hedge funds can invest both long and short, so investors aren’t taking a directional bet on whether the markets will go a certain way. Other asset classes have more binary outcomes.
Hedge funds can also employ derivatives and options, which don’t typically factor into traditional asset classes. These nontraditional tools can help investors manage risk and seek higher returns – important considerations in a volatile environment where good returns are hard to find.
“Hedge funds also have a more fluid structure than, say, an equity mutual fund. They can migrate between asset classes, a flexibility that other pools of capital lack,” says Wolf.
The Fed has introduced an interest-rate hiking cycle in an effort to rein in persistently rising inflation. Rising interest rates directly impact a variety of hedge fund spread-based arbitrage trading strategies. When interest rates increase, arbitrage spreads widen, thus increasing an investor’s expected return. Merger arbitrage
“The rising-interest-rate landscape could bode well for a few different hedge fund strategies, such as merger arbitrage. In fact, it’s one of the few asset classes that’s yielded a positive correlation with interest rate. As rates continue to rise, the spreads on deals and rates of return could increase,” says Wolf.
Merger arbitrage has promise beyond its relationship with rising interest rates. As a sector, it adjusted well to increased regulatory scrutiny – and there’s a backlog of deals that didn’t close in 2021 but could present opportunities in the future.
Fixed-income relative value
Rising interest rates also set up the fixed-income relative value subsector of the hedge fund universe for potential success.
“When rates rise, the same shift in the yield curve at a lower level will lead to a more magnified move at higher levels. So fixed-income relative value spreads tend to widen out to more attractive levels,” says Wolf.
As a result of what Wolf describes, investors may be able to get the returns they’re seeking with less leverage than a strategy may have used in the past. Or, if leverage stays constant, the investor’s return would likely increase.
On top of this, many hedge fund strategies – but fixed-income relative value in particular – use derivatives to express investment goals. This means they tend to hold a significant amount of unencumbered cash across their portfolios. Before this interest-rate hiking cycle, there would have been virtually a 0% return on this cash.
“With rates ratcheting up, cash can earn a return too,” says Wolf. “It isn’t necessarily a huge part of fixed-income relative value returns, but it’s favorable for investors all the same.”
One last development adding to the case for hedge funds is the advent of investable hedge fund indices. Historically investors have had to allocate a significant amount of time and cost to perform manager due diligence. Hedge Funds’ inherent flexibility is a double-edged sword in that while it makes them attractive for the current environment, it also drives significant dispersion in returns between managers. So an investor can make the right decision about a sub-strategy, but they also need the hedge fund they have chosen to perform as anticipated. The ability to replicate hedge fund indices and their sub-strategies by directly investing in the funds changes that.
Learn more about how hedge funds can help battle rising rates and inflation.