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Why rising rates are changing the hedge fund case
Global government bond yields keep climbing as a stalemate in the Middle East holds Brent crude around $107 a barrel, and UBS says central banks have signalled that rates are likely to stay elevated near term, with inflation sticky and growth resilient. In a recent note, the bank argued that this is the kind of environment in which hedge funds have tended to do well, and that it supports allocating to a few specific strategies.
What UBS points to
UBS says hedge funds have posted positive cumulative returns in every Federal Reserve tightening cycle since 1994 and have generally beaten global bonds. In the latest cycle it says global bonds fell about 12% while hedge funds finished with gains. UBS is careful to add that higher rates do not guarantee strong hedge fund performance. Its argument is that when money costs more, company fundamentals, policy differences and relative valuations matter more, which creates more room for skilled managers.
Three strategies, three conditions
- Equity market neutral. These managers buy some stocks and short others so that overall market moves largely cancel out, leaving stock selection as the main driver of returns. UBS says that is helped now because financing costs reward strong balance sheets over weak ones. The average S&P 500 stock is carrying implied volatility of around 2.5 times the index, against a more typical 1.8 times, while average correlation between stocks is about 0.08, versus a median of 0.23 since 2002. In plain terms, stocks are moving more on their own news and less together.
- Discretionary macro. These managers use judgment to take positions across countries, currencies, commodities and interest rates, without needing a single call on where rates go. UBS says central banks responding differently to local conditions widens the range of outcomes and loosens the links between markets.
- Fixed income relative value. These managers seek to profit from pricing gaps between related bonds instead of betting on the direction of yields. UBS notes the US 2-year Treasury yield has risen about 130 basis points over the past year, against about 110 for the 10-year and about 85 for the 30-year. That changes the shape of the yield curve and creates mismatches to trade.
UBS also sees a role for multi-strategy funds, which can shift capital between these opportunities as conditions change.
The risks and the caveats
This is one bank’s view, and UBS rates fixed income as Attractive, so it is making a case for an allocation. Hedge funds also come with costs and constraints that UBS lists itself: leverage, limited transparency, volatility, higher fees, illiquidity and longer lockups. It says historically high leverage in relative value makes manager selection especially important. Most individual investors cannot access these strategies directly, so the note is best read as an explanation of how they work.
What could change the picture
The argument rests on rates staying high and policy staying uneven. Faster rate cuts, an end to the oil stalemate, or central banks moving in step again would weaken the case for macro and relative value in particular. Stock correlation rising back towards its long-run norm would reduce the edge UBS sees for market neutral managers.
This article was written by Eamonn Sheridan at investinglive.com.
