When Markets Are Volatile, Hedge Funds Earn Their Stripes

05.22.2017 - Wayne A. Sprague

Hedge funds have encountered a number of challenges in recent years, both from an economic and competitive standpoint. But things are changing.

Many of the headwinds that have weighed on performance are fading, disappearing, or in some instances completely reversing. Economic activity has picked up and interest rates are rising, possibly ushering in an era of reflation that could present hedge funds with new opportunities to generate alpha and demonstrate their value as a volatility-management tool.

Hedging Portfolio Volatility

In our view, the most important role hedge funds play in diversified portfolios is defensive. Because hedge fund returns aren’t usually aligned with returns from traditional asset classes, hedge funds can help smooth out the ride when the stock or bond market is experiencing a volatile period, cushioning a traditional long-only portfolio. In other words, they can reduce risk by hedging a portfolio against market volatility and rising rates.

Volatility has been muted in recent months, but the landscape is shifting. As the US enters a rising-rate environment after almost a decade of persistently low rates, we expect bouts of market turbulence to become more frequent. So the value of hedge funds and other alternative investments as portfolio diversifiers could become much more apparent. This pattern may already be taking shape: In the first quarter of 2017, a period that included a Fed rate hike, hedge funds posted their strongest quarterly performance since 2013.1

Event-Driven Opportunities

In addition to their defensive qualities, hedge funds could see more attractive return opportunities as economic activity picks up, especially if tax reform and repatriation encourage companies to make acquisitions. “Event-driven” hedge funds invest in securities of companies in the midst of events such as bankruptcies, changes in capital structure and mergers/acquisitions. When a company announces plans to make an acquisition, its stock price typically falls due to the uncertainty surrounding a purchase, while the stock price of the target company usually rises. Event-driven hedge fund managers take a long position in the target company’s stock and sell short the acquiring company’s shares.

The Industry Evolves

Along with the economic forces that are influencing the industry, change is also happening from within. The hedge fund industry has grown increasingly crowded over the past 30 years. What was a cottage industry dominated by a handful of competitors in 1990 is now a marketplace of 8,216 hedge funds and approximately $3.07 trillion in assets under management.2 This level of overcrowding, combined with higher administrative costs and recent performance challenges, has contributed to the attrition we have witnessed in recent years.

But consolidation could be good for the hedge fund industry—and for investors. It is possible that the strongest competitors will survive while funds that consistently underperform or draw the attention of regulators fall by the wayside. We are also observing a new level of willingness among hedge fund managers to revisit the terms of their investment agreements, exploring more investor-friendly alternatives to the traditional 2/20 fee model (a management fee of 2% of assets and a performance fee of 20% of investment returns). Some funds are offering lower fees in exchange for longer lock-up periods, which restrict the ability of investors to withdraw from hedge funds for a pre-determined length of time, usually around a year.

Other firms are offering more flexible fee arrangements or imposing higher return thresholds before they receive performance fees. The details vary from firm to firm, but the industry’s willingness to explore new pricing models is encouraging because it demonstrates the willingness and ability to adapt. The hedge fund industry also continues to grow. Despite some liquidations and investor withdrawals, assets under management increased by $121 billion in 2016, thanks in part to performance gains. Flows generally aligned with performance: funds with the strongest returns brought in assets while funds that underperformed experienced the most significant outflows.

Finding the Perfect Manager

Our objective is to find hedge fund managers who are the “best fit” for each of our clients, based on the client’s individual goals, investment horizon and risk tolerance level. While each situation is unique, we see similarities among many of the managers we allocate capital to; including a high level of transparency, competitive fees and a verifiable track record of attractive after-tax returns that are not closely correlated to the markets. We search the broad universe of hedge funds to identify managers who use leverage judiciously, which can reduce the chances of a fund experiencing serious financial difficulties.

As the hedge fund industry works through this period of transition, we will continue to monitor the third-party managers we allocate capital to, as well as the regulatory environment, economic trends and competitive forces that are influencing its evolution. For more information about our manager-selection process or investing in hedge funds, please contact your Fiduciary Trust portfolio manager.

1. The HFRI Fund Weighted Composite Index is used as a proxy for hedge fund performance.
2. Source: HFRI.

This communication is intended solely to provide general information. The information and opinions stated are as of May 22, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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