Last year was a solid year for hedge fund performance overall, but in 2018, many of these funds may have an opportunity to shine brighter. Morgan Stanley Wealth Management expects euphoric market conditions to subside and overall returns to be more muted as earnings growth peaks, interest rates rise and volatility picks up. Those conditions could allow hedge funds to outperform broader market indices.
While volatility was near multiyear lows at the start of the year, macroeconomic factors—like rising global inflation, increased political uncertainty and divergent monetary policies—have contributed to increased volatility and lower correlation levels between individual securities. Both can be positives for hedge funds.
Now that the “melt up” environment appears to have subsided, we believe hedge funds will have the opportunity to produce attractive results from both long and short positions. As always, manager selection will remain a critical component in allocation decisions as there will likely be greater dispersion among returns due to an increase in volatility as the market cycle progresses.
A Look at 2017
Hedge funds are private investment portfolios that are often constructed with expectations of performing well whether broader markets rise or fall. Hedge funds usually shine brightest when volatility is high and global markets aren’t trading in sync--that’s when active managers may have the most impact on generating returns. When global markets correlate, it’s harder for active managers to outperform their benchmarks.
Unlike mutual funds, hedge funds have very high minimum investment requirements, can only be redeemed at set intervals (often quarterly) and typically take a percentage of profits as a performance fee in addition to the management fee.
Some hedge funds take positions that aim to limit downside exposure. Those have a cost, like an insurance policy, and don’t pay off in rising markets. Other funds take short positions in investments they expect to fall in price. It’s difficult to make money on shorts when markets are rising in unison.
These conditions are changing. Since the U.S. presidential election in late 2016, while broad market indices have been heading higher, individual securities have posted a wider range of returns, allowing some hedge fund managers to seize opportunities.
Already, 2017 hedge fund performance was superior to 2016. The Hedge Fund Research Inc. (HFRI) Fund Weighted Composite Index rose 8.7% last year. This is in contrast to 2016, when the same index returned 5.4%. That year hedge fund performance suffered as managers were surprised by events like a plunge in oil prices, Brexit and the U.S. election.
Hedge funds have produced positive results in each of the past 14 months, representing a record number of consecutive months of positive returns for the HFRI Fund Weighted Composite Index. The standout performers last year were technology funds, long/short equity funds and structured credit funds (which buy tranches of securitized debt instruments). They climbed 14.8, 13.3% and 7.8%, respectively, according to HFRI data.
Another positive in 2017: Flows into hedge funds increased. In 2016, hedge funds experienced $70 billion of net outflows, according to Hedge Fund Research. Conversely, during 2017, total hedge fund industry capital increased by $59 billion. They had a record $3.21 trillion in assets by the end of the year.
A Look at Specific Strategies
While overall hedge fund performance has generally improved, not all strategies have benefited equally. Below are a few trends in the performance of different strategies to keep in mind as the year progresses:
Equity long/short: Funds that pick stocks, taking both long and short positions, performed well last year. Health care and technology sub-strategies were the standouts. Not surprisingly, funds that took significant short positions experienced performance challenges as the market broadly moved higher.
Global macro, or funds that make investments based on forecasts for global markets, didn’t do great in 2017, but we think they could be well-positioned for the future as we expect global market volatility to rise. Divergent monetary policy could create opportunity in foreign markets.
Managed futures funds, which buy and sell futures contracts, could also offer compelling opportunities. They lagged in the first three quarters of 2017, but ended the year in positive territory after strong fourth quarter performance.
Activist strategies, where portfolio managers aim to influence company management, have underperformed. This is partly because they usually have a value focus and growth strategies have outperformed lately. In 2018, however, activist managers may benefit from a rotation from growth to value.
Event-driven funds, which invest in companies going through major events, such as restructurings, debt exchanges and mergers and acquisitions, experienced modest 2017 performance. But 2018 is expected to be a good environment for deal-making, which could create catalysts. The repatriation of foreign cash may also lead to opportunities for these funds.
Market neutral and relative value strategies, which typically have low correlations to stock indices, produced low-to-mid single digit results in 2017, lower than stock markets. But their risk-adjusted returns were attractive. Such returns may seem more attractive in 2018.
Hedge funds employ a mix of unique strategies. They should be evaluated based on how well they meet the objectives and risk parameters set by management and not in comparison to a specific asset class. After a year like 2017, when stock markets around the world returned more than 20%, a single digit hedge fund return may not look that tempting. But in 2018, if markets get more volatile, that may well be a different story.
The above was excerpted from the alternatives special report,” Hedge Funds Deliver Improved Results Despite Low Volatility.” For a copy of the full report, please ask your Morgan Stanley Financial Advisor.
