It’s been a historically unfriendly environment for hedge funds these past few years – that is, one of low volatility and depressed interest rates. While there have been specific investment approaches that have bucked the odds, at the same time some very large funds have shuttered and returned capital to investors, with a few subsequently transforming into family office vehicles.
Meanwhile, the wave of instability roiling the global markets of late, affecting not just equities, but also typically non-correlated assets like commodities (including a dramatic inversion in energy markets among crude and natural gas) has caught even more managers off guard, in particular those with momentum-driven portfolios (where all it takes are a few sizeable wrong-way bets to upend an entire operation). Hedge Fund Research revealed liquidations outpacing launches during Q3, including some 174 total fund closures through the period, a 40% increase from the previous quarter. Accordingly, a barbell-type scenario has developed, with funds that have successfully adapted faring reasonably well, while those unable to adjust to market conditions rapidly falling out of favor.
So how do investors know which strategies are on the right track? When it comes to gauging hedge fund prowess, particularly during periods of sustained volatility, a key industry metric remains the Sharpe ratio, devised by William Sharpe as a way to codify risk-adjusted rates of return. As one might expect, funds with the highest ratios achieved the most consistent returns and, theoretically, garnered more investor capital as a result. Preqin, in conjunction with the Alternative Investment Management Association (AIMA), recently used the Sharpe benchmark to assess hedge fund RoR relative to traditional investments and found that alternatives continued to generate steadier returns on a risk-adjusted basis than equities and bonds, both in the short-term as well as over 3-, 5- and 10-year periods.
What happens when risk-free rates of return finally begin to look competitive on a relative basis? If a manager cannot boost performance to offset the rise in money market accounts, CDs and other safe-haven products, excess return disappears and thus the Sharpe ratio declines.
To wit, many observers see ongoing rotation out of traditional hedge strategies and into the likes of debt, infrastructure and other private capital funds during the coming year. Pension giant CalPERS recently announced a major private equity investment model in the making, and other key public and private plan managers have also indicated increased allocations to debt funds, real estate, private lending and related opportunities.
As defense-minded managers navigate through a succession of see-saw sessions, many are once again looking at cash as an acceptable short-term solution. It’s been some time since money funds have held any sway: exactly a decade ago Fed funds bottomed at .25%, an all-time low, and would remain just north of nil throughout the Fed’s lengthy easing campaign.
As such, and until very recently, investors essentially risked losing money if sitting on too much liquidity. But with the Fed maintaining a moderately anti-inflationary stance, the subsequent uptick in rates means one can now get paid for holding onto cash, particularly when parked for an extended period.
Going forward, the likelihood of continued uncertainty bodes well for liquidity – that is, without a sure-fire play elsewhere, building one’s cash reserves becomes the most logical approach, allowing firms to comfortably hold cash while pondering their next move based on evolving market conditions.
It’s especially welcome news for funds that by design maintain large cash positions. Commodity trading advisors or CTAs, for instance, primarily get their exposures through futures products, which structurally include inherent leverage. As such, even when fully invested from a target exposure perspective, they typically maintain a sizable cash position. The same can be said for many Macro traders using both on-exchange and OTC derivatives to achieve their desired exposures. It mattered little when risk-free rates were near zero; today, however, getting north of 200bps on undeployed cash is a pretty big deal for these cash-flush entities.
The cash comeback has also created a bump in demand for services that cater to the management of cash, as well as collateral, treasuries and other liquidity services. Hedge fund managers would be well-advised to speak with their custody and banking partners about programs such as collateral management and cash investment products whereby they can reduce counterparty risk, diversify asset allocation and realize additional yield on excess cash, without increasing their operational risk and costs. Firms like BNP Paribas are making investments in enhanced cash solutions to better serve clients during this period of increased market volatility.
Macro state of play
As has been the case since the end of QE3 four years ago, the words and deeds of the Federal Reserve Board continue to inform investor sentiment. With the economy still relatively sound and labor market conditions holding steady, in December the Fed raised its target rate another quarter point to 2.25-2.5%, the fourth such move of the year. At the same time, however, Fed chairman Jerome Powell announced that 2019 adjustments would be scaled back in response to increased market volatility, as well as evidence suggesting some slowing in overall US growth.
Though rates in the US remain well below their historical average (roughly 5.69% going back to 1971), equities repeatedly took a pounding as 2018 ground to a close—evidence that investors have other concerns besides rising rates. Indeed, the outgoing year has seen a host of macro and geopolitical issues weighing on the markets, making things all the more difficult for global competitors.
The persistent downward pressure toward year’s end has some soothsayers calling for an unwinding of the now decade-old bull run. At the same time, the dislocation of some markets (such as energy, rates and FX) has only added to the growing sense of unease.
Accordingly, funds that have had a decent stretch may be looking at hedging long positions, or simply reallocating into lower risk and/or cash alternatives. Data suggests such activity has already escalated, as managers increasingly plot a risk-neutral course until some clarity can develop. Assuming a continuation of current volatility, 2019 is likely to determine which hedge fund managers have what it takes to stay ahead of the curve.
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Andrew Dougherty is Americas Head of Asset Managers and Alternative Investors for BNP Paribas Securities Services in New York.