While market and economic experts continue to debate landings – soft, moderate, or hard – the US economy continues to defy expectations, and the mix of alpha and beta coursing through the markets is creating a multitude of new, or at least renewed, opportunities for hedge fund investors across strategies. Furthermore, alpha appears to be shifting from macro to micro, and we envision a positive return to sound research and stock-picking. If we have learned nothing else over the last five years, it is that anything can happen. On the geopolitical and policy front, over 50 countries, comprising half the world’s population, are holding national elections in 2024, from Russia to Taiwan, the UK to India, and the United States. As always, the outcomes are wild cards.

In our latest outlook, we dissect the primary drivers supporting our favorable outlook for the asset class – with cautionary tales, of course – and delve into the implications and opportunities for our sub-strategies.

Market outlook

What a difference a year makes. Two of our three macroeconomic scenarios at the mid-year point in 2024 suggest a more favorable climate for risk assets going forward, which bodes well for more alpha opportunities and should reward stock picking.

Given this view, we have made several upgrades to sub-strategies we believe stand to benefit the most, including new positive grades for Macro’s Systematic diversified, Equity hedge, and three of our Event Driven sub-strategies, including Activist, Special situations, and Merger arbitrage. Conversely, this shift has led us to downgrade several of our Relative value strategies, including Fixed income sovereign, Fixed income corporate, Relative value volatility, and Macro’s Discretionary thematic.

abrdn strategy ratings

Equity

Benign conditions for risk assets combined with an environment that should reward stock-picking acumen points to strong returns for equity long/short managers. We have elevated Equity hedge to a positive rating. We also see idiosyncratic risk reappearing as the macro picture becomes clearer. We have retained our positive rating on Equity market neutral, including our discretionary and systematic funds, which continue to perform well.

With two of our three macro scenarios suggesting upward movement in equity markets, we are cautiously confident that beta will continue to propel Equity hedge performance going forward. While hedge fund crowding in narrowing equity markets is an acute risk to short-term performance, focusing on working with a diversified roster of equity hedge managers can be an effective counter and deliver uncorrelated alpha. The big story is alpha, specifically, how its underlying drivers are quickly shifting gears from macro- to micro-driven and returning to an emphasis on traditional fundamentals such as earnings.

Against a backdrop of reduced policy uncertainty and moderating inflation and rate volatility, we see strong stock selection returning to the fore as a lead alpha generator, with macroeconomic factors lurking as always but likely more muted. The pendulum could easily swing back to macro being the lead dispersion driver at any time, with key elections worldwide still to take place and the potential for more policy uncertainty, additional rate or inflation jolts, and heightened geopolitical tensions.

Equity valuations remain stretched but reasonable given the current earnings' realities. We see US equities continuing to trade at a reasonable premium with higher profitability factored in, but we are also wary of the US risk premium, which is dangerously low and could correct at any time should data disappoint. A stable, lower-rate environment could also bring micro and small-cap opportunities, particularly given the expected pickup in M&A activity.

Momentum and large-cap stocks should continue to drive markets higher. Equity hedge managers, particularly those with a quant bent, should continue to benefit due to the pivotal role momentum plays in their approach. Large cap growth companies are generally perceived as defensive plays, but with so many mega-tech companies working on artificial intelligence (AI), there is alpha to be had. But, as always, not without risks. If the crowded technology trade unwinds or slows dramatically, the rotation could be painful, reinforcing alpha diversification's importance.

Event-driven

Multiple macro trends are moving in the right direction for Event-driven strategies, setting the stage for a strong end to 2024. Stabilizing rates, less policy uncertainty, improving CEO confidence, the higher cost of capital, cash-rich corporates, and mounting pressure on private equity (PE) sponsors to deploy excess dry powder to fuel deal activity are creating an environment conducive for activists to drive shareholder value through operational turnarounds and strategic reviews. We also anticipate an uptick in idiosyncratic alpha, a more favorable stock-picking environment, plus more corporate activity, such as recapitalizations and restructurings.

Accordingly, we are upgrading the Activist, Special situations, and Merger arbitrage strategies to positive as we believe each strategy could generate returns above the 3- and 5-year realized returns.

In the current growth-constrained environment, with credit harder to come by and equity back in favor, PE sponsors and other asset owners are working doubly hard to find value-creation levers to pull in their portfolio companies. This points to a more sustained level of Activist activity through the end of this year and beyond as PE firms and their companies seek to expand margins through operational improvements and push for strategic M&A. Japan is a market to keep a close eye on, as the opportunity set could be massive, with the Ministry of Trade and Tokyo Stock Exchange both advocating for shareholders' rights and opening their arms to Western investors.

While beta plays a key role in both Activist and Special situations strategies, alpha comprises more of the return component for Special situations managers (Chart 1). These managers hunt for value across different parts of the capital structure, with an emphasis on restructurings, spinoffs, add-ons, or even bankruptcies. Opportunities should abound for special situations managers amid increasing dispersion and more activist/PE/corporate activity percolating. Managers will likely target new positions in both undervalued strategic assets ripe for M&A and post-spinoff companies with high potential value.

For Merger arbitrage, the continuing high-rate environment should prop up forward-looking returns, with stabilizing capital markets supporting more future deal activity (Chart 2). Most of the activity in this space will be driven by companies looking to grow strategically, potentially through add-ons, and by PE sponsors under the gun to put more capital to work.

Despite the low headline default rates, we remain neutral on Distressed debt, where more than $160 billion in distressed debt is trading today. Nearly half of the defaults that do happen are being worked out via alternative capital solutions, enabling more companies to avoid Chapter 11 filings. For companies that default, the success rate on loan recoveries is poor, making it imperative to fully understand the value upside and the risk downside.

Macro

Absent a major, unanticipated macroeconomic shock, on par with COVID for context, we see volatility across all markets and asset classes lowering and exerting pressure on several macro and relative value strategies, including Discretionary thematic, which we have downgraded to neutral. Conversely, the likely backdrop of growth remaining steady in the US with the potential for an ex-US growth boost – while inflation stays clingy – would be a big plus for risk assets globally, hence our upgrade of Systematic diversified to positive.

The potential for lower interest rate and foreign exchange fluctuations overall will likely limit trading opportunities within developed markets. G3 interest rates and G10 FX typically account for the lion’s share of Discretionary Thematic returns, and the market has priced in the strong likelihood of the overall opportunity set shrinking. While equities and commodities can often be effective hedges in discretionary thematic portfolios, their abilities will be seriously tested, given our positive outlook for these asset classes.

While we expect some temporary volatility spikes due to ongoing geopolitical events and the impacts from this extended period of money-tightening policy, we see these dynamics creating more tactically oriented trading opportunities than significant trends warranting more capital and risk to be deployed. While this makes us neutral on traditional developed market interest and FX-focused Discretionary thematic managers, we are positive on the opportunity sets going forward for emerging markets specialists and commodity-focused strategies.

Recent positive trends in both the equity and commodity markets should continue, providing a strong tailwind for Systematic Diversified returns. More muted interest rate and currency signals have provided a nice uptick in performance for systematic diversified managers, and we expect this will continue through the year-end. Also, any rate normalization in the form of cuts would benefit systematic diversified strategies, which have historically produced the bulk of their returns in lower-rate environments. Another positive development is that while Systematic diversified assets are growing, so too is interest and demand from institutional investors. This growing book of business is catalyzing more asymmetrical price moves and trend-focused opportunities across markets. As we make our way out of 2024 and into 2025, we favor the more trend aware and directional strategies over those with Relative value models, though we would note that both are positioned to fare well given current and projected market conditions.

Relative value

The bright outlook for risk assets will make it very difficult for fixed income strategies to come close to maintaining the pace of growth they have experienced in recent years. Fixed income volatility is declining precipitously from historically high levels, and cash/futures spreads continue to narrow. After a strong two-year run, we are downgrading our Fixed income sovereign, Fixed income corporate, and Fixed income convertible arbitrage strategies back to neutral status.

Fixed income sovereign returns will be challenged as volatility and dispersion among G3 yield curves continues to moderate, compressing the investable universe for more than just the short term and reducing opportunities in cash futures basis trading. That said, Fixed income sovereign should still be appealing on an absolute value basis, though investors will need to tamp down their alpha expectations relative to the 5% per year performance they have achieved since the 2008 Global Financial Crisis. Barring an unforeseen event that would generate new opportunities, we expect median peer group performance to start to revert to the mean. Geographically, the best opportunities will be US-focused while Japan could show upside with more volatility, though this is a lesser-trafficked, more specialist-oriented market.

The tightening of credit overall, and the increasing emphasis on covenant-lite issuance to get deals done prompts us to downgrade Fixed income corporate to neutral status, with a trend line moving closer and closer to negative.

We remain neutral on Fixed income convertible arbitrage, where spreads will continue to tighten but primary issuance should surge. In the US and Europe, convertibles should benefit from lower rates over the next 12 months, maybe less so in Asia, and most hedge fund managers see the technology sector, driven by all things AI, continuing to offer the most value.

Last, our positive grade remains in place – at least for now – for Fixed income asset-backed as spreads stay wider in the securitized markets, particularly in collateralized mortgage-backed securities. Residential mortgage-backed securities should perform well, considering strong home value appreciation, lower unemployment, and new financial solutions being developed to allow more people to purchase homes.

Finally, we have downgraded Relative value volatility as we envision lower cross-asset volatility, producing fewer trading opportunities and putting downward pressure on manager returns. While we anticipate limited opportunities in relative value volatility trading, this could change quickly, considering the unpredictable macro and geopolitical picture.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.

Past performance is not an indication of future results.

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Hedge funds use sophisticated investment strategies that may increase investment risk in your portfolio. Among the risks presented by hedge fund investments are: the use of unregistered investments, which may make it difficult to assess the performance of the holding; risky investment strategies, which may result in significant losses; illiquid investments that may be subject to restrictions on transferability and resale; and adverse tax consequences.

Investments in asset backed and mortgage-backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.

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