Tough times for markets highlight the appeal of hedge funds

10-year US Treasuries fell last week as yields rose 18 basis points, while the S&P 500 fell 4.8% in its worst week since June.

This pattern has been evident for much of the past year. Earlier this month, the Bloomberg Global Aggregate Total Return Index fell into the bear market, losing more than 20% from its 2021 peak.

History suggests that fixed income will resume its traditional role as a diversifier. Periods when rolling 12-month total returns fell simultaneously for stocks and bonds were followed by periods of strong performance. Since 1930, 12-month bond performance after such periods has been 100% positive, with an average return of 11%.

But we think investors should also look for other sources of portfolio diversification, and we see hedge funds as well positioned to weather the current market volatility.

Hedge funds continue to prove themselves at stabilizing portfolios. Based on the latest HFRI Fund Weighted Index, released Sept. 15, hedge funds gained 0.4% mom in August, compared to a 4.2% decline in the MSCI World Index and the Bloomberg Global Aggregate Total Return index by 4%.

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All strategies, with the exception of equity hedging, posted positive returns in volatile markets as the outlook for inflation and economic growth became the primary concern for markets heading to the Jackson Hole Economic Symposium. Year-to-date hedge funds have also outperformed overall. The HFRI Fund Weighted Index fell 4% from the start of the year to the end of August, while the MSCI World Index posted a negative return of 17.8% and the Bloomberg Global Aggregate Total Return Index fell 15.6%.

Certain hedge fund strategies can perform well in volatile and sideways markets, an environment we expect to continue into next year. In our view, a lasting improvement in market sentiment is unlikely until political risks and macro and monetary policy uncertainty abate. Inflation fell at a slower-than-expected pace based on a better-than-expected August CPI reading. Following that disappointment, we expect this week’s Federal Reserve policy meeting to deliver a third straight rate hike of 75 basis points, along with renewed signals that it will tighten further until inflation is contained.

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The political risks also remain elevated. Despite Ukraine’s recent progress in retaking territory, our baseline scenario is that the war is likely to continue through at least winter, with no ceasefire in sight. Meanwhile, China’s decision to stick to its zero-COVID policy increases risks to global growth. Certain hedge fund strategies, particularly global macro funds, have the potential to perform well in such difficult conditions.

Growing divergence between sectors and markets is expanding opportunities for hedge funds. We have emphasized that investors need to be selective in increasing their exposure and we see scope for value stocks to continue to outperform, along with more defensive parts of the equity market including consumer staples and healthcare. Non-directional hedge fund strategies can be particularly well positioned to capture opportunities on both the long and short sides of the market that are outside the domain of traditional managers or strategies.

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So for the remainder of the year we see an increasing role for hedge funds as markets remain volatile, central bank rates continue to rise and divergences between sectors or regions increase.

Main Contributors – Mark Haefele, Tony Petrov, Christopher Swann, Linda Mazziotta, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original Report – Tough times for markets underscore attractiveness of hedge funds, September 20, 2022.

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