Traditional portfolios may not cut it today

The current market environment is marked by high inflation and rising interest rates. And thus far this year, there has been one equity market sell-off after another. But, it’s important to remember that despite the US Federal Reserve (Fed) hiking cycle, interest rates are still relatively low and even though equity market sell-offs have been common, equity multiples are still relatively high.

The current situation is pretty unique compared to historical periods of market stress. It’s been a long time since the Fed raised rates absent an above-average growth backdrop. When rates rise but growth is strong, equities tend to do well. But right now, growth isn’t strong and rates are rising anyway in a bid to tame inflation.

These dynamics have made it hard for traditional 60/40 portfolios to generate returns, leaving investors searching for alternatives. As an asset class, hedge funds have historically done well in challenging market environments like this.

Why hedge funds?

Hedge funds could be a compelling answer to today’s uncertain markets chiefly because they’re so flexible. Hedge funds can invest both long and short, so investors aren’t taking a directional bet on whether the markets will go a certain way. Other asset classes have more binary outcomes.

Hedge funds can also employ derivatives and options, which don’t typically factor into traditional asset classes. These nontraditional tools can help investors manage risk and seek higher returns — important considerations in a volatile environment where good returns are hard to find.

Hedge funds also have a more fluid structure than, say, an equity mutual fund. They can migrate between asset classes, a flexibility that other pools of capital lack.

Rising interest rates support hedge fund investing?

The Fed has introduced an interest-rate hiking cycle in an effort to rein in inflation, which has been on the rise for some time. Rising interest rates directly impact a variety of hedge fund spread-based arbitrage trading strategies. When interest rates increase, arbitrage spreads widen, thus increasing an investor’s expected return.

Merger arbitrage

The rising-interest-rate landscape could bode well for a few different hedge fund strategies, such as merger arbitrage. In fact, it’s one of the few asset classes that’s yielded a positive correlation with interest rates (Chart 1). As rates continue to rise, the spreads on deals and rates of return could increase.

Source: Bloomberg, Hedge Fund Research, abrdn, June 2022.

And this sector has promise beyond its relationship with rising interest rates. This market has adjusted well to increased regulatory scrutiny and there’s a backlog of deals that didn’t close in 2021 but could present opportunities in the future.

Fixed-income relative value

In particular, rising interest rates also set up the fixed-income relative value subsector of the hedge fund universe for potential success. When rates rise, the same shift in the yield curve at a lower level will lead to a more magnified move at higher levels. So fixed-income relative value spreads tend to widen out to more attractive levels.

As a result, investors may be able to get the returns they’re seeking with less leverage than the strategy may have used in the past. Or, if leverage stays constant, the investor’s return would likely increase.

On top of this, many hedge fund strategies, but fixed-income relative value in particular, use derivatives to express investment goals. This means they tend to hold a significant amount of unencumbered cash across their portfolios. Before this interest-rate hiking cycle, there would have been virtually a 0% return on this cash. Now, with rates ratcheting up, cash can earn a return too. It’s worth noting that this isn’t necessarily a huge part of fixed-income relative value returns, but it’s favorable for investors all the same.

Hedge funds filling the gaps in a typical portfolio

In the current market environment, amid rising interest rates, widening spreads and volatility, we believe that a typical 60%/40% portfolio may not provide investors with the returns they hope for. But while these conditions threaten traditional portfolios, they may create opportunities for hedge fund investors seeking to fill the gaps.

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IMPORTANT INFORMATION

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.

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.

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