Three reasons to consider hedge funds now

Preparing for a changing context

05 January 2018

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2017 was a good year for the global economy and global equities, and in 2018, we expect equities to make further gains. But shifts in monetary policy, correlations and more broadly, a maturing economic cycle, mean that investors need to adapt to a changing investment context. This will require a combination of a more agile approach to investing, a diversified portfolio, and a discipline to focus on the long-term to avoid common investing pitfalls. Here is why, in this context, hedge funds can help your portfolio.

Hedge funds benefit from rising rates

Monetary policy normalization will remain a focal point for 2018. With global growth expanding at its fastest pace in six years, central bankers will likely continue to view the economy as strong enough to withstand stimulus withdrawal and higher interest rates. However, not all asset classes perform the same under these scenarios. Based on historical data, we find that hedge funds are fairly resilient to rising rates - on an absolute return basis, hedge funds have typically outperformed most other asset classes, with fixed income performing worst of all.

More differentiated markets need more sophisticated strategies

At turning points in monetary policy, markets typically become more responsive to idiosyncratic factors - investors may have noticed the sharp decline in macro and micro correlations over the past few months. With solid growth but changing macro trends and rising interest rates, movements of securities within and across markets have become less correlated, creating more winners and losers. Investors who have been favoring traditional passive instruments may now be forced to review their allocations and seek active strategies that are more agile and focused on individual company performance. This is the focus of many hedge funds. Their alpha generation typically increases in these periods given the broader set of trading opportunities they can take advantage of.

More challenging times ahead require action now

"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria” – Sir John Templeton.

Investors are rarely prepared for a downturn. CIO does not believe that we have entered euphoria territory yet, but ensuring that strategic allocations are ready to navigate more volatile periods should start now. Based on historical data, in every year that the S&P 500 has fallen, hedge funds in aggregate have lost less than the overall market. Some strategies, such as CTAs (commodity trading advisors), even generated some of their best returns during market meltdowns. This capacity to limit losses has also allowed hedge funds to recover faster than equity markets.

2018 is unlikely to be easy for investors and while we do not see cause for alarm, we acknowledge that changing market conditions call for action. We believe hedge funds will play an increasing role in multi-asset class portfolios. Depending on their profile, we advise under-allocated investors to revisit their investment strategy and consider an allocation to hedge funds with a focus on being well-diversified across strategies, managers and regions.

How have hedge funds performed in past downturns?