Inflation, growing geopolitical instability, slowing global economic growth, reduced liquidity in capital markets, de-globalisation, concerns around ‘Big Tech’, a still-lingering global pandemic and an uncertain U.S. political outlook, are all keeping investors guessing.
Given this abrupt pivot in market conditions, following a decade of predictability and low risk, investors are grappling with the question of where to turn to for returns.
Yet in this challenging environment, hedge fund strategies have shown themselves to be resilient and useful tools for mitigating portfolio risks. Many strategies have successfully navigated market declines and have taken advantage of volatility and market divergence.
The global nature of the inflation spike, Covid disruption, and the effects of war in Ukraine, mean that virtually all asset classes have been impacted this year. Both the absolute price of securities, as well as the relationships between securities, have created price anomalies that hedge funds can benefit from.
Here’s our outlook for the four main hedge-fund strategy categories in 2023:
- Macro. Macro strategies invest across equity indices, credit indices, currencies, commodities and interest rates. They can invest directionally across these markets (betting on whether they go up or down), as well as on a relative-value basis (one asset class versus another).
We feel that this strategy is best placed to take advantage of the current trading climate. Although central bank monetary policy has started to catch up with inflation (and forward inflation expectations), the path ahead remains uncertain, likely keeping macro-trading opportunities high.
When central banks are tightening, and concern over the prospects for macroeconomic fundamentals remains acute, macro strategies have the most ‘tools in the tool kit’ to capitalise on the market’s response. - Event driven. These strategies seek to profit from corporate developments, such as spin-offs, mergers or other corporate ‘events'. We think so-called ‘merger arbitrage’ – when investors simultaneously buy the stock of a target company and sell short those of the acquiring company – can deliver attractive risk-adjusted returns in this current environment.
Interest-rate hikes and a complex regulatory landscape have created wider deal spreads (higher return potential) for corporate deals that are ‘in process’.
That said, there’s a higher bar to overcome for any new corporate activity with CEO confidence now languishing at levels not seen since the 2007/08 global financial crisis. What’s more, limited new deal flow elevates re-investment risk.
But when market volatility abates, even moderately, there will likely be significant demand for new transactions. Elsewhere, we’re expecting an increase in investor-activist campaigns as more companies trade at incorrect valuations. Companies are more likely to be mispriced today, relative to their intrinsic value, attracting interest. - Credit Corporate bonds will become an increasingly attractive asset class, not only on a total-return basis, but also for distressed and structured products, amid an interest-rate hiking cycle that’s poised to end in the first quarter of 2023.
Significantly higher rates and wider bond-yield spreads – the additional yield over the risk-free rate – over the past year have created remote credit-risk issues, with high single-digit yields and short-dated maturities.
Moreover, a sustained period of high rates is likely to slow the global economy and present more defaults and restructuring opportunities. During recent periods of higher volatility, investors often behaved irrationally, creating inefficiencies between assets, and across assets within a corporate capital structure.
This benefits strategies that target relative value or arbitrage (profiting from prices differences in different markets) opportunities.
Finally, structured credit is likely to benefit from favourable technical dynamics with less price support from the Federal Reserve and bank balance sheets for the foreseeable future. - Equity hedge. The outlook for global stocks is highly uncertain. Tracking an equity index will almost certainly fail to produce the returns that investors took for granted during the period of extraordinarily loose financial conditions following the global financial crisis.
That said, the opportunity set for beating the index – generating alpha – is looking increasingly attractive. For example, short alpha – a strategy of selling overpriced securities – has generally been very lucrative.
Investor pessimism has sharpened market scepticism with regards to corporate earnings robustness and growth prospects. Share prices have been punished across the board.
But as the economic picture clears up, the market will become more discerning based on individual company earnings and prospects – an ideal environment for bottom-up stock-pickers.
On the long alpha side (buying under-priced securities), while we’re not predicting a sharp market rally, equity valuations have dropped across many sectors, with growth sectors, in particular, experiencing a sharp derating in share price.
Looking ahead, valuations and stock-price movements will become increasingly dependent upon corporate earnings – in other words more idiosyncratic.
Final thoughts
In order to meet required returns, investors need to diversify their traditional holdings and identify alternative sources of return in this uncertain economic climate. The higher inflation, slower growth environment is not expected to reverse in the near term. A decade of easy policy and currency printing will take some time to unwind.
Against this backdrop we’re excited about what hedge-fund strategies can offer and have identified attractive pockets of opportunities across most of the strategies that we target. Hedge-fund investors that can invest across asset classes, both long and short, are uniquely placed to capitalise on the investment opportunities that will arise in 2023 and beyond.
That said, as highlighted above, the different investment strategies have different fundamental drivers, and as such not all hedge-fund strategies deliver the same underlying risk and return characteristics. While we're enthusiastic about the general backdrop, investors should be mindful of the risks, and should consider the differing investment roles the strategies play in the context of their broader asset-allocation decisions.
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.