Some hedge funds are finally seeing market conditions justify their existence
Hedge funds must adapt this year to a radically different market environment. For some, life has become much more difficult. But for others, these are precisely the conditions they have been waiting for.
A new world of high inflation, sharply rising interest rates and rapid quantitative easing, almost unimaginable just a few years ago, has rocked equity and bond markets over the past six months. Eurozone inflation this week hit a new record high of 8.1%, increasing pressure on the European Central Bank to accelerate rate hikes.
High-growth technology stocks were particularly hard hit. Although they can reach huge valuations when interest rates are close to zero, higher rates mean that their potential future earnings look relatively less attractive. Tiger Global and some of the other “Tiger cub” hedge funds that flourished during the bull market felt the brunt of this selloff, in some cases losing far more than the broader market.
But for some managers who focus on exploiting price differentials between stocks, the conditions are now in their favour. They had been frustrated by the “all rally” in which investors often seemed uninterested in whether they were buying a high or low quality company. However, the removal of very low-cost financing that has long been available to businesses is beginning to separate the wheat from the chaff.
“Market Neutral [equity] and low net funds should benefit equities . . . reflecting the fundamentals now,” said Kier Boley, chief investment officer of alternative investment solutions at UBP, referring to funds that try to make money by weighing one stock against another, rather than betting mainly on rising prices.
A perfect example of how terms have changed for these funds is London-based Sandbar Asset Management. A year ago, I wrote in this column that the company with $2.2 billion in assets, founded by former Millennium trader Michael Cowley, was grappling with the seemingly illogical way markets worked. .
For example, the correlation between an improvement in a company’s earnings expectations and its stock price reaction, which should intuitively be positive, had fallen “to levels not seen in the last decade”, said Sandbar at the time. In some sectors such as aerospace, it had even turned negative, meaning that improving earnings expectations would actually lower the stock price. Sandbar ended the year down 7.5%.
Much has changed since then. The fund rose 6.7% in the first four months of this year, compared with a 7.3% decline for equity hedge funds on average, according to data group HFR, and a 14.5% decline of the S&P 500 index from Wednesday. .
Significantly, so-called alpha – industry jargon for the money a manager earns through skill rather than simply following overall market movements – has been positive for the fund during each of the last four months.
One of the main reasons, according to Sandbar, is the fact that the markets have now entered the “late stages of the economic cycle”. He wrote in a letter to investors that this historically represented a time when conditions were most favorable for funds like him. This is because “dispersion [between stocks] rises significantly” while returns simply following the market fade or turn negative.
The unwinding of positions by other investors late last year and early this year as the market declined has created profit opportunities for Sandbar in recent months, he added.
While the outlook for these managers has improved significantly, there are still factors that could still impede their progress. Stocks have rallied over the past two weeks on hopes that bad news about the economy will persuade central bankers to limit interest rate hikes. And, as UBP’s Boley points out, even if a manager gets a correct analysis of a stock’s fundamentals, their positions can still be skewed by a major investor unwinding their portfolio.
Nonetheless, this industry sifting, long anticipated but often delayed by years of central bank stimulus, is welcomed by many.
Hedge funds have struggled for much of the past decade to justify why investors should pay their high fees when returns were often uninspiring compared to index funds – available at a fraction of the cost – or compared to profits apparently offered by private equity funds.
In a world where stock and bond yields are now less attractive, hedge funds that don’t just try to ride the markets but rather exploit market dislocations may have finally hit their stride. .