The Return of Volatility: Why 2023 is Bringing Renewed Interest in Hedge Funds
What are the recent trends in both hedge fund performance and investor demand?
Freddie Parker: Hedge funds are coming back into focus, particularly for institutional investors. One reason is the strength of recent performance, including a record level of outperformance in 2022 versus the 60/40 portfolio as hedge funds protected capital against what was clearly a very turbulent and dislocated market environment. While aggregate performance has been strong and hedge funds broadly delivered portfolio diversification, dispersion remains high with the individual managers and some of the underlying hedge fund strategies.
Looking beyond the recent past, I think a lot of this renewed focus has to do with the forward-looking opportunity set. The expectation—both from allocators and based on historic data— is that hedge funds will benefit from a higher rate environment going forward. Historically, hedge fund returns have been higher, with better alpha, during periods of rising rates, which are also generally accompanied by a more challenging beta opportunity set. As a result, we're seeing a refocus on active management more broadly, and in the hedge fund context especially, I think an expectation that we're moving to more of an alpha-oriented market environment versus the last decade, which was more beta-oriented given the zero-interest-rate policy, QE-backed world we lived in.
Where do you see current investment opportunities?
Taylor O’Malley: The strongest opportunity set for our suite of strategies right now is equities, macro, and commodities; we view credit as a bit trickier right now, with attractive opportunities likely still a few years out.
The relative attractiveness of strategies is constantly changing. For the last half-decade, global macro and commodities have been in the desert, but those spaces—particularly macro—have become more interesting. In the macro space, particularly with the rates bent, it will be pretty interesting, but not all macro is created equal. In the commodities space, the key areas for us are gas and power. Energy as it relates to oil is hard to capitalize on, so we are more focused on spreads and the like.
For equity long/short, the first quarter in particular was a bit tricky, but my sense is that the next couple of quarters could be really quite interesting. The market-neutral equities business is a bit tougher on the start of the year, but with winners and losers emerging as we move away from a central bank and government-controlled bull market, we'll continue to see a lot of excitement there. If you think about the equity long-short space, it's market neutral. For the last decade, they've endured effectively free money. So there really weren't many losers, but there were a heck of a lot of winners. And so that subset is also incredibly interesting to us right now.
Parker: We came into the year with really record low levels of exposure to the InfoTech complex more broadly, but also software specifically. And we've seen strong flows into that space. Last year was all about being long cyclicals as an expression of an inflation trade, and this year there is a move back to growth sectors with significant valuation downgrades.
Jack Springate: It's been a really dynamic start to the year, particularly in the rates markets. In these trending markets, we tend to see large, sustained moves that are punctuated by shorter-term reversals, whereas elsewhere returns have been very much in-line with expectations. Earlier this year, for example, we saw the biggest single-day move in bond markets since 1987, in what was a major reversal from the sustained trends of last year. As we try to digest the market environment this year and look forward, the only consensus maybe is that there isn't really a consensus on the outlook, which is what creates the opportunity. Managers generally think that central banks are going to have a really tough time threading the needle of containing inflation in the face of a fairly fragile economic outlook.
The general sentiment is that defensiveness may be needed in the short term, but over the medium term, managers are looking offensively at the opportunity set in a period where we may see much, much wider dispersion than we have for a long time. The dispersion and the dislocations make it also very interesting for opportunistic investing, particularly through a co-investment program. There's a scarcity of great managers in the industry, with more good ideas than there are good managers. If you also have a means to move dynamically and access the best ideas, a co-investment capability is particularly helpful. Co-investors have been seeing an unprecedented inflow of sourcing, particularly in the credit distressed space; equity-oriented opportunities exist as well, but these tend to be idiosyncratic fundamental opportunities with dislocated situations.
How is the current market environment being reflected in managers’ positioning?
Parker: We have a fairly unique overall setup, which reflects the managers views of a strong alpha opportunity set, but maybe a lack of consensus on market direction. We have very high gross exposures in our book at the top-ends of a three- or five-year lookback, whereas net exposures are close to the bottom of the ranges. This illustrates managers that are risk-on in terms of the alpha opportunity set both long and short, but overall wanting to keep their market exposure contained.
The key trend has been the expansion of short books, particularly in equity-oriented strategies via the short rebate (i.e., the interest that you're earning on the cash proceeds of short sales), and clearly the setup in a high rates environment is better for shorting generally higher rebates. For most of the past decade the short rebate has actually been zero or in some cases negative, providing an additional headwind to short sellers who also grappled with a broadly rising market. On average in our PB book, managers currently are earning over 400 bps of short-side rebate on S&P 500 names. Beyond that, there is more confidence in single-name short opportunities, with the balance of our book moving away from shorting with macro products—futures, ETFs, index products, baskets, and more—and back into the realm of single-name shorting.
Higher rates have also benefitted any strategy that has a cash component, due to the increased yield. One example is derivatives-heavy strategies where you have unencumbered cash that's being held on the sidelines and isn't being posted as margin. All of this, I think, just helps to reinforce what is a strong macro opportunity set with this simple mechanical dimension that makes managers' lives easier.
What are the long-term implications for hedge fund portfolio construction?
Springate: Our fundamental belief is that skill-based return is really valuable, but it's also scarce and the dispersion is vast between winners and losers. To identify true skill, you need an effective due diligence process combined with a long investment horizon.
The benefits of an allocation to the top skill-based hedge funds are long-term and are valuable in most environments, but there are certainly some regimes where these benefits are more visible than others. And frankly, where there are some regimes where the return on skill effectively may be higher than others as well.
Looking at returns since the 1990s, when the Fed funds has been 50 basis points or below – so call it a low-rate environment – the S&P returns balloon; however, using a broader hedge fund index as a proxy for skill, returns suffered in the low-rate environment but improved in normal-rate environments. The biggest driver was the alpha component, which begs the question of why this is the case? And as you go through each strategy area, the theme generally is bigger trends and more dispersion, but it plays out in multiple ways. The volatility today is reminiscent of the 1970s and 80s, when big trends and high volatility dampened Sharpe ratios; however, if you had strategies that were able to capture strong trends, it was actually a record period for return. We think a similar story has been playing out in equity markets, and more recently we’ve seen developments in the credit space too.
O’Malley: Philosophically, we don't believe that you can rush capital in and pull capital out at just the right time. Instead, you must be everywhere at all times to monetize the opportunities when they show up. No one expected the Ukraine war. No one expected the natural gas trade last year. But you can't all of a sudden try and get into that trade after things are starting to happen. We start with an annual plan of how we anticipate allocating capital, then we do a bottoms-up analysis for all the teams and what we believe the capacity could be. But on top of that, the PMs then regulate their own capital, raising or lowering exposure based on the opportunity set.
How should investors think about single strategy HFs versus multi-manager platforms?
Parker: We've seen strong, sustained demand for multi-managers driven by strong historical returns not only for top managers, but also for the average multi-manager. I think what investors have really prized is the strong risk management capabilities of these managers, which tend to be market neutral and deliver downside protection and capital preservation, and in some cases positive returns, against some of the most severe market downdrafts in recent years. And then beyond that sort of performance dimension, I think there are some innate characteristics of these firms that investors really like.
There's obviously the access to talent that they have, which I think has become increasingly differentiated. Certainly, the flow of talent we've seen away from single manager firms in many cases into multi-managers has meant that the pool of talent that they are picking from has grown and been enriched. There's also scale benefits, which is unusual for hedge funds. These firms seem to work better as they get larger and are able to establish competitive moats through best-in-class systems and data infrastructure that attract top talent.
One point allocators have made is that while these firms are complex and difficult to diligence, but the end result is a higher level of confidence when an allocation is made because of the diversification that these firms offer and the repeatability that they've proven in delivering returns.
O’Malley: We're still operating under the same core thesis that we started when we began 20 years ago: build consistent, repeatable, diverse return streams by attracting the best talent with quality infrastructure and best-in-class risk management. While this thesis hasn't changed, what's required to achieve it has changed. The strategy set required to actually enable repeatable returns with consistency and diversity has never been wider across equities, macro, commodities, credit, and systematic.
On the talent side, high-caliber managers are gravitating to multi-strategy firms similar to ours that can compete economically and also provide an advantage by providing resources such as data infrastructure that are required to compete but can be difficult to maintain for single managers.
Even with resources, it can be difficult to attract outside talent. We're very big on development programs within the firm to create our own portfolio managers from senior analysts. We've run hundreds of training programs throughout the year to improve how they think about their investment process and to learn from each other. For example, PM calls, which we've done for decades, used to be a corporate tax. We used to yell at people to do them. Now the PMs actually lead the calls in what is probably one of our most productive discussions that happens on a weekly basis.
Springate: When allocating to hedge funds, investors run into two common risks: unforeseen correlations between managers, and the relatively high use of leverage. Both risks can be amplified during periods of market volatility, particularly as many managers may move in a coordinated way. Our approach is geared to having as much exposure as we can with our highest conviction ideas. We start with a focused sourcing and diligence process to identify who has the key characteristics, quality of leadership, infrastructure, the organizational alignment, the talent level to be able to grow and ultimately compete, but separately look for ways you can build your portfolio in a different way, in an orthogonal way to multi-strategy platforms through other strategies that you don't necessarily see there.
One of the reasons for the renewed interest in the fund-to-fund model versus 5 or 10 years ago is because it’s become more difficult to build a comprehensive portfolio from scratch. It's a way of accessing top-tier managers while also having allocations to strategies that are developing to build out a lot of inherent diversification.
