Reflecting on the past year, the markets have navigated a complex landscape marked by firm growth in the US and a potential pick-up in ex-US growth, while inflation has remained persistently high. This backdrop has painted a positive picture for risk assets globally. However, sticky inflation has kept global central bank policies constrained, dampening both volatility and the potential range of interest rate and foreign exchange rate changes. Despite these challenges, returns from hedge funds, while lagging equities, have been relatively strong.
As we look ahead to 2025, the environment and opportunity set for hedge funds is as favorable as we have seen in the last decade. The positive alpha environment, characterized by increased pairwise correlation and dispersion across markets, is particularly beneficial for Equity Hedge and Event-Driven strategies. Additionally, the positive trend environment for systematic Macro strategies and the asset-backed opportunities in fixed income further enhance the potential for strong performance. 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.
Hedge fund sub-strategy outlook
What a difference a year – or an election result – makes. The outlook for risk assets in 2025 presents three distinct scenarios, each highlighting the increased relevance of hedge funds in navigating market complexities.
- In the base case, with a 60% probability, the US experiences steady growth while Europe and Asia moderate. Inflation remains sticky, limiting the Fed's ability to cut rates significantly. This scenario is positive for risk assets, with equity markets continuing to rise, credit spreads staying tight, and capital markets opening up for new issues and refinancings while commodity prices remain stable.
- In the bull case, which has a 15% probability, significant policy easing in China, including housing developer bailouts and measures to boost household consumption, leads to robust global growth without exacerbating inflation. This allows central banks to ease monetary policy. The result is very positive for risk assets, with equity markets rallying over 10%, credit spreads tightening to historic lows, and capital markets becoming highly active, accompanied by rising commodity prices.
- The bear case, with a 25% probability, involves a recession in the Eurozone and UK, escalating geopolitical conflicts, and a US recession triggered by Trump policies, leading to sharp Fed rate cuts. This scenario is negative for risk assets, with global equity markets selling off by 10% or more, credit spreads widening significantly, and a flight to safety and quality assets.
In this complex outlook, where volatility is no longer suppressed by the Fed, hedge funds play a crucial role. They can navigate the increased market volatility and exploit opportunities across different scenarios, making them more relevant than in the past decade.
Given this view, we have a positive outlook for Equity Hedge’s two sub-strategies: Equity Long/Short and Equity Market Neutral, which we believe, means they can outperform their historic returns. Conversely, this shift has led us to neutral outlooks for strategies that perform better through periods of market dislocation, credit stress, and high volatility. We expect returns for these strategies to be in line with historic returns. Sub-strategies such as Macro's Discretionary Thematic and Relative Value: Volatility play a crucial role in portfolios due to their ability to capitalize on market dislocations. We believe Macro's Discretionary Thematic can adeptly navigate changing economic landscapes and geopolitical events, while Relative Value: Volatility strategies can exploit pricing inefficiencies and volatility spikes, providing valuable diversification and risk management in turbulent market conditions.
abrdn strategy ratings
Equity
Beta is likely to continue being a tailwind, with continued upward movement in equity markets. Lower pairwise correlations and increased dispersion across developed markets support the environment for positive alpha, meaning idiosyncratic risk will drive performance more than macro risk.
While global equity valuations remain expensive, they are heavily influenced by a high concentration in single stocks. Continued rate cuts could further drive earnings growth and spur more capital market activity, which typically benefits small and mid-cap (SMID-cap) companies. Additionally, hedge fund crowding in narrow equity markets shows signs of easing.
The big story is alpha, specifically with Equity Hedge. A benign environment for risk assets combined with a positive outlook for stock picking alpha should support strong returns for long-biased equity long/short managers (Chart 1).
Chart 1. Popular hedge fund positions are outperforming
Event-Driven
A pro-business administration, interest rate stabilization, cash-rich corporates, and pressure on private equity sponsors to deploy capital are expected to increase future dealmaking and corporate activity. The market beta inherent to directionally long strategies like Activism and Special Situations will continue to be a tailwind.
Idiosyncratic alpha is also expected to be a return component, as a more favorable stock-picking environment and increased corporate activity signal more opportunities for value-plus-catalyst investing across the capital structure. Special Situation managers continue to flex across different parts of the capital structure, focusing on restructurings and financial simplification, spin-offs and portfolio simplification, acquisitions, capital return plays, and bankruptcies.
We continue to prefer managers who can take advantage of selective “fat pitches” in Distressed, while possessing the skill set to use other investment strategies such as capital structure arbitrage and event-driven trading.
For Merger Arbitrage, expect deal activity to be driven by strategic corporate deals and private equity's need to deploy capital. Given recent antitrust interventions, spreads are more attractively priced.
Macro
With a backdrop of growth remaining firm in the US and potential for acceleration in ex-US growth, alongside sticky inflation, the outlook for global risk assets remains positive. Sticky inflation may constrain global central bank policies, dampening volatility and the potential cone of interest rate changes and foreign exchange rate fluctuations. We continue to expect short-lived volatility spikes, not least due to the ongoing conflicts and political turmoil. However, this is unlikely to reverse a trend of a further gradual normalization in the volatility regime across all asset classes.
Historically, this has resulted in an environment where Discretionary Thematic managers generated below-average returns. Outside the core developed markets, we see pockets of opportunities across emerging markets and Asia ex-China, which could be a return drive for the space. Also, in a lower probability scenario where the US moves into a recession, and as a result, a larger-than-expected interest rate-cutting cycle is introduced; this would be positive for Discretionary Thematic managers. We are, therefore, maintaining our neutral rating on the strategy.
As mentioned, we see well-telegraphed paths for developed market interest rates, mostly trending lower. Contrary to discretionary peers, systematic managers historically have benefited from a steady trend lower in rates.
We anticipate trend-focused opportunities within equity markets, where the rally from the past two years is expected to broaden further, driven by strong earnings, deregulation, and lower corporate taxes. A slow grind higher for equity markets would generally benefit Systematic Diversified managers. We acknowledge some risks to this view, namely our wariness of commodity markets, which has been a notable contributor for systematic managers over the past few years.
We are also similarly concerned about a noisy foreign exchange market under a new Trump administration. We believe that headline-grabbing tariffs and other policy announcements will make it more difficult for quants to generate consistent alpha, as these markets can be prone to whipsawing. However, overall, we still see the drivers as positive for the Systematic Diversified space.
Relative Value
Fixed Income: Sovereign manager returns remain attractive on an absolute basis, and managers continue to benefit from high levels of yield on US-unencumbered cash/assets. However, the excess return (alpha) expectations relative to cash yields are more muted compared to 2021-2023. The individual underlying drivers of Fixed Income: Sovereign returns remain neutral to neutral-positive. Volatility and dispersion in G3 yield curves have moderated, compressing opportunities relative to the past few years (Chart 2).
Chart 2. Six-month Rolling Return Move Index vs. CS Fixed Income Arbitrage Index
The opportunity set is currently almost entirely driven by US trading, both in cash versus futures and in other strategies. Although managers still have access to sufficient balance sheet, there are signs of increased funding costs in the US. We expect dispersion amongst the peer group, driven by instruments/strategies traded and fund size. Funds that can shift geographical allocation aggressively toward US relative value trading and smaller funds will likely perform better in the near term.
While corporate credit spreads are near 5-year lows, that’s not entirely the story for structured credit, leading us to remain positive for Fixed Income: Asset Backed. Spreads remain wide for CMBS conduit, with many investors blindly shunning commercial mortgage pools with exposure to office. Residential mortgage-backed securities continue to remain attractive, given its strong appreciation of home prices and low unemployment. Second-lien mortgages and other financing solutions to allow “house rich, cash poor” buyers are emerging, and non-QM residential transition loans are now available in the institutional securitized market. Finally, Significant Risk Transfer (SRT) is a growing market that is becoming more competitive but remains attractive. SRT is more competitive in the US, and issuance may decline under a looser bank regulatory environment.
We remain neutral on Fixed Income: Corporate. High-yield and leveraged loan spreads are tighter than long-term averages, so while there is room for further tightening, particularly for loans, the excess return available is less attractive going forward.
The early August market shock that started in Japan and reverberated across global markets kicked off a short-term upward trend in volatility across asset classes into the US presidential election. Since this event, however, we’ve seen a steady decline in volatility across all asset classes except for currencies.
This recent trend has kept several of our Relative Value: Volatility strategy drivers (trends in volatility, levels of volatility, and volatility of volatility) neutral. Although spot volatility levels across asset classes are low (cheap) relative to the past few years, we continue to see more limited forward-looking opportunities in relative value volatility trading. Volatility trading could be one area of opportunity, as this asset class will be most impacted by headline-grabbing tariffs and other policy announcements, particularly in the short term.
Final thoughts
As we move into the first half of 2025, the hedge fund landscape is marked by opportunities and challenges driven by changing economic conditions and policy shifts. The next US presidential administration’s pro-business stance, along with stable interest rates and increased corporate activity, creates what we believe is a positive environment for risk assets, active management, and alpha generation. Our outlook suggests strong performance in Equity Hedge and Event-Driven strategies – especially those targeting Activism and Special Situations. The expected rise in dealmaking and corporate restructuring activities provides a fertile ground for value-plus-catalyst investing. Meanwhile, Systematic Diversified strategies are poised to benefit from ongoing market trends, although close monitoring is needed for policy announcements under the new administration. However, traditional strategies in Systematic Diversified might grind due to limited opportunities in interest rates and currency trades. A cautious approach is essential. Despite the challenging economic landscape, we continue to believe hedge funds offer many opportunities for attractive returns and can also provide a source of diversification should the outlook turn more negative.
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.
The guidelines for ratings are as follow: Positive: We believe the strategy will outperform its long-term average; Neutral: We believe the strategy will perform in line with the long-term average; and Negative: We believe the strategy will underperform its long-term average.
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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