October was the best month of the year for hedge funds. The HFRI Fund Weighted Composite Index climbed +1.3%, bringing this year's gain to +7.2%.
But, far from a one-off, there are reasons to expect hedge fund returns – from equity hedge strategies in particular – to continue to improve and potentially outperform market benchmarks:
- Hedge funds typically outperform other asset classes when rates are rising. In the US, during the past three rate hiking cycles over the last 20 years, long/short (+13.4%), event-driven (+11.4%) and relative value (+8.3%) indices all exceeded returns for the S&P 500 (+7.6%) on an annualized basis.
- Falling correlations should help managers generate alpha. Thirteen-week rolling correlation between S&P 500 stocks is currently 8.6%, compared with a 25-year average of 17.5%. From 2000–2016, equity long-short strategies generated average annual alpha of 6.5% or more when correlation was lower than the median.
- S&P 500 stock price dispersion is currently low, but valuation dispersion between the cheapest and most expensive stocks is very wide. This suggests price dispersion could rise substantially if investor focus shifts to valuations – creating an attractive environment for equity long-short hedge fund strategies.
So, depending on each investor’s risk profile, CIO recommends investing between 14-18% of a portfolio to hedge funds as part of a balanced strategic asset allocation.