By Susan Barreto, Alternatives Watch
As institutional investors consider alternative investments in anticipation of market shifts, inflation is a new factor that could impact hedge fund portfolios acutely.
As inflation fears swirl with the greater demand post pandemic in consumer and industrial goods, it is likely there will be a central bank response of raising interest rates. Few are taking bets on when this will occur, but the inevitability is clearly dominating the asset allocation moves of institutional investors.
According to fund of hedge fund provider K2 Advisors, hedged strategies are primed to do well in both rising and falling interest rate environments. Given the increase in performance dispersion across regions, sectors and asset classes, hedged strategies can help battle the rising rate environment, experts said.
“We believe these [hedged] strategies are particularly interesting now as a fixed-income diversifier given the potential for renewed economic growth and an uptick in inflation,” Brooks Ritchey, K2’s co-head of investment research and management, recently wrote.
Hedge fund performance provider PivotalPath asserts in its latest research that historical hedge fund returns show that equity diversified, equity sector and credit funds have been the top performers in periods of rising inflation, while global macro and managed futures lag behind.
“Given these concerns, for the first time in nearly a decade, allocators are seeking our counsel for how best to analyze the positioning of their hedge fund exposures given various inflation-related scenarios,” said PivotalPath officials.
The firm derived its recently released insights on a study of 23 years of market and proprietary hedge fund data. They relied on the 10-year Treasury yield as a proxy for rising rates. The firm tracks roughly 200,000 data points across more than 2,000 institutional hedge funds and $2.3 trillion of industry assets.
As interest rates increase, the S&P historically tends to generate very strong performance and boosts the bar for hedge funds. According to Pivotal Path, when the 10-year yield increases the S&P 500 has annualized returns at 21% compared to 12% in its hedge fund composite.
But when interest rates arrive at their higher level and stay there at roughly 3%, all hedge fund strategies outperform the S&P 500 substantially.
Then as rates move back down, all hedge fund strategies outperform equities along the way.
The PivotalPath Hedge Fund Composite Index annualized at approximately 9% compared to the S&P 500’s 1% during those time periods of falling rates.
Back at K2, the firm has been bullish on its long/short equity investments, as officials expect active sector-oriented management to create alpha in the next 12 months as the U.S. stock market has hit new highs in 2021.
In the most recent outlook analysis, Ritchey said, “While hedged strategies are designed to generate low volatility returns over the medium and long term, they also help limit losses during various market shocks.”
He used the example of the first quarter 2020 as the COVID-19 concerns drove down the stock market. He added that the low equity sensitivity characteristics of a multi-strategy hedge fund portfolio helped a balanced portfolio of stocks and bonds to preserve capital.
For periods of inflation, capital preservation is key as hedge fund returns that have been strong so far this year will remain in the spotlight.