Turning to hedge funds for yield

Market volatility has seen multi-strategy hedge funds make a comeback this year but how have these returns been generated and what are the structural opportunities for investors looking for yield?

24 Nov 2020

3 min read


Kevin Russell

Chief Investment Officer, O’Connor


Global financial markets are polarized. On one side are the optimists who see a COVID-19 resolution as inevitable by the middle of 2021 and expect expansionary fiscal policy around the world. Discussions among this cohort often transition to the potential for value stocks to outperform and inflation risks to steepen yield curves in both the US and Eurozone. On the other side are the “lower for longer” group, who see structural headwinds to inflation and virus challenges extending well into 2022. This cohort continues to focus on secular growth names that benefit from a low interest rate environment.

As is usually the case, we expect the real answer here is somewhere in the middle of these bookends, and we see equities, factors (common attributes of securities that shape different return and risk profiles), and interest rates as likely more range-bound, albeit in a substantially more volatile range than we have seen in the years prior to 2020.

Even as we contemplate the possibility of inflationary pressures and higher interest rates as we are reminded of the historically low nominal interest rate environment currently, we are focused on structuring our portfolio to thrive in a low interest rate environment. So, when the inevitable questions come from investors on where to find income for their portfolios, we are ready and advise that alternatives can really deliver in this regard.

Two areas where we are seeing tremendous value and see as structural opportunities for investors looking for yield are private credit and trade finance.

Many alternatives strategies, especially absolute return strategies like multi-strategy hedge funds, offer a risk and return profile that more closely mirrors a credit or income strategy allocation like high yield bonds than it does equities.

This results from the broad construct with which hedge funds approach the market: largely hedging beta, sector, and factor risk, and profiting from relative value discrepancies and inefficiencies in the global equity and credit markets. Increasingly, we are seeing investors recognize this fact and request distributing share classes to complete the yield replacement idea by enabling the strategy to deliver current income for investors.

Additionally, the flexible mandates and broader product capabilities that exist among alternatives asset managers have allowed capital to be allocated to segments of the credit markets from which banks and broker-dealers have had to retreat due to regulatory pressures.

Five-year trailing performances – equities and high yield vs. volatility

Indices

Indices

Total return (%)

Total return (%)

Average 21D Volatility (annualized) (%)

Average 21D Volatility (annualized) (%)

Indices

S&P 500 Index

Total return (%)

72.0

Average 21D Volatility (annualized) (%)

14.5

Indices

Bloomberg Barclays US High Yield Bond Index

Total return (%)

35.6

Average 21D Volatility (annualized) (%)

3.7

Two areas of potential yield

Two areas where we are seeing tremendous value and see as structural opportunities for investors looking for yield are private credit and trade finance. While there is inevitably a trade-off in liquidity for investors and a small trade-up in complexity, we have conviction that those risks can be managed and that investors are being well compensated by getting additional carry and often credit enhancements relative to more liquid credit strategies. 

Our expectation is that investors will continue to increase their private credit allocations over the next several years, and we believe that the trade finance space will rapidly evolve through securitization and become a replacement for many investors looking for short duration income.

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