Three years ago we launched our first Ucits Liquid Alternatives fund in Europe, the Franklin K2 Alternatives Strategies Fund. At the time, some would have argued that the macroeconomic conditions were not favorable for certain hedge fund strategies. We agree they haven’t for a number of years, but now we think this may be changing. Monetary policy looks to be shifting in some countries, currencies are becoming more volatile and geopolitical risks have intensified of late. We think these fundamental elements could drive alpha opportunities for skilled hedge fund managers to capture.
Many think that hedge fund strategies are super-charged and high-octane. We would argue hedge-fund strategies are actually meant to be dull, with low volatility. But hedge fund strategies can also provide diversification and long-term capital growth potential.(1)
In our view, low interest rates are often an overlooked factor in regard to hedge-fund strategy performance. Now, as US interest rates are making slow but steady strides upward from historic lows, we think certain hedge fund strategies may be finding new opportunities to show their mettle.
If the US Federal Reserve (Fed) continues to raise interest rates this year and next, we think it could cultivate an environment for certain hedge fund strategies’ to flourish. Rising interest rates have historically been associated with lower cross asset correlations, creating more alpha opportunities for hedge funds.
Additionally, rising interest rates have typically led to future periods of above average alpha, as represented by the Hedge Fund Research Index Fund Weighted Composite Index (HFRIFWI).(2)
The illustration below shows a positive correlation between alpha and interest rates. The average level of alpha rose to the highest level at 14.07% during the measured period, where the US 10-year Treasury yield stood at 7.05%.(3) Based on what we’ve seen in the past, we think hedge fund managers could have the opportunity to capture that alpha, or outperformance, as US interest rates continue to rise.
Global geopolitical risk is another element that we believe should drive a change in the landscape for hedge fund strategies. On the back of recent geopolitical tensions, major currency spreads have widened, and historically wider spreads have benefitted hedged strategies’ alpha. This is particularly noticeable within the Group of Seven (G7) economies (4), since they coordinate and attempt to manage major exchange rates in a way that leaves their currencies closely linked.
As a result, we might not yet be in the golden era for hedge fund strategies – the most-ideal environment for managers to capture alpha – but we could be approaching the silver era, where favourable opportunities are starting to appear.
Allocating toward market themes
Not all hedge strategies will fair equally as conditions change. We expect the event-driven hedge fund space, for example, may face headwinds as central banks globally begin to normalise interest rates. Event-driven hedge funds often seek to profit from merger and acquisition (M&A) corporate activity, which could be diminished as interest rates rise.
Global macro strategies, however, may benefit from rising rates. The global macro space has seen an increase in trading volume over the last two months, and we anticipate this trend will continue.
To conclude, we’ve seen evidence that the current market landscape could become a nurturing environment for certain hedge fund strategies, but we’re only just at the beginning and believe more opportunities could crop up during this silver era.
Brooks Ritchey is senior managing director, head of Portfolio Construction, at K2 Advisors
1 Diversification does not guarantee profit or protect against risk of loss.
2 Alpha calculated relative to the S&P 500 Index. The HFRI Fund Weighted Composite Index (HFRIFWI) is a global, equal-weighted index of over 2,000 single-manager funds that report to Hedge Fund Research Inc. Database. All indexes are unmanaged and you cannot invest directly in an index. Unlike most asset classes, HFR Index returns reflect fees and expenses. Past performance is not an indicator or guarantee of future performance.
3 Alpha is calculated against the S&P 500 index.
4 The Group of Seven is a group consisting of Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.