Hedge funds and rising interest rates
Lombard Odier research suggests an environment of rising interest rates should be positive for hedge fund performance.
Hedge funds and rising interest rates
Our research suggests that hedge funds may offer a better risk-adjusted proposition in an environment of higher or rising rates, relative both to some traditional investment strategies and to their own recent past. The cycle of increasing rates will present a different set of opportunities and challenges from an eventual environment of higher interest rates. We believe the three broad hedge fund sub-sectors (Alpha, Market and Liquidity - see below for more details) will each be impacted differently by changes in the interest rate environment.
Our approach to the hedge fund universe
The hedge fund universe is not a homogenous asset class and largely defies generalisations. Any categorisation is therefore by definition somewhat arbitrary, but here we refer to the three broad, risk-based classifications employed to guide our own private bank’s portfolio construction process. We believe each of these strategies will exhibit its own idiosyncratic performance sensitivities: Alpha Strategies – These types of hedge fund seek to generate returns regardless of market direction. They include funds which bet on macroeconomic trends ("Global macro" funds) and those which seeks to exploit differences in stock prices by being "long’ and "short" stocks (see Glossary) in a certain sector or geography ("Equity Market Neutral" funds). They also include those which use complex mathematical strategies to buy or sell futures contracts across asset classes, usually following market trends ("managed future" or "CTA" funds).
Market Strategies – These funds take market risks, and include those which take long and short positions in stocks, depending on the managers’ views of the companies in question ("Long Short Equity" funds)
Liquidity Strategies – These funds supply liquidity to certain markets and include those which bet on specific events such as the successful completion of mergers and acquisitions (“risk arbitrage” funds), or those which invest in distressed debt as well as those arbitraging small market inefficiencies.
US interest rates - the Federal Reserve is ready for “lift-off”
The Fed Funds rate1 is now 0.75% above the historic low that prevailed for much of the period following the global financial crisis. We predict it will rise from its current 1.00% to 1.25%-1.50% by end 20172. Meanwhile, longer term market rates are reversing an easing trend that had been in place for more than three decades. Thus, the potential impact of a shift to a higher rate environment on investment portfolios has become a key concern to investors. By definition, a rising rate environment which begins with rates at close to zero and credit spreads (or the difference in yields between two bonds of similar maturity but different credit quality) at historic lows is going to be challenging for traditional fixed income investors. The implications for equity investors are less clear-cut, but we believe volatility is likely to rise irrespective of absolute performance. As such, allocators are increasingly looking to hedge fund strategies as a possible response to a looming sea-change in the market backdrop.
Here we examine how hedge fund strategies may be affected by the end of the long-term easing cycle and extended period of near-zero risk free rates. With most hiking cycles pre-dating the inception of the modern hedge fund industry as we would recognise it, and a rise in policy rates from current levels being unique in financial market history, there is no meaningful industry track record that can be reliably compared to a sustained trend of rising rates. As a result of this shortage of pertinent empirical data, our analysis draws primarily on a qualitative and intuitive understanding of how hedge fund strategies function, supported by the limited data available.
CTA or managed futures funds
CTA or managed future strategies typically aim to capture market trends, which are likely to be more prevalent when there are trends in the underlying drivers of markets, such as rates. The implied relaxing of market ‘manipulation’ by central banks that comes with allowing rates to rise should also increase the correlation between prices and fundamentals and hence reduce correlations between markets. Again, this would be positive for these strategies, as the benefit of their broad diversification between markets becomes more apparent when underlying market outcomes are more independent and dispersed. One possible counter to this optimistic view stems from the observation that CTAs have made a substantial part of their historic returns from riding rates lower. CTA managers argue that trend-following profits can equally be earned in an environment of rising rates, but we believe is likely that this opportunity will be less consistent.
Many of the arguments that apply to managed futures strategies apply equally to the discretionary macro sector. Additionally, the fundamental nature of these types of funds implies that a closer link between economic fundamentals and financial market pricing, as implied by a normalisation in rates, should be beneficial to performance.
Long Short Equity
Interest rate cuts are typically a symptom of economic weakness, and monetary loosening is unlikely to be initiated during a period of robust growth in stock prices. Conversely, rate rises that are intended to cool the effects of robust economic growth or inflation are bound to occur when equity markets are rising (at least in nominal terms). Given the basic maths of the long/short proposition (longs can appreciate infinitely while shorts can only fall to zero; long positions get larger if successful while short positions shrink) we believe equity hedge funds will, in general, perform better when markets rise.
Beyond this perhaps banal observation, there are other compelling reasons to believe that an environment of rising interest rates might also be one that is conducive to long/short equity investing.
Since 2007, policymakers globally have been artificially manipulating the cost of capital to an unprecedented extent through low or negative rates and asset-buying programmes, creating perverse incentives and outcomes. One result is that natural competitive forces have to some extent been suspended and this has clearly complicated the job of the stock-picker. Weaker companies have been thrown liquidity lifelines and near-zero discount rates have inflated the value of even the most meagre cash-flows. Reckless indebtedness has effectively been rewarded, while otherwise poor capital allocation decisions have been flattered by the ability of almost any investment to out-earn its cost of capital.
Meanwhile, the inability of investors to meet their yield objectives from fixed income markets has caused dividend-paying stocks in many cases to attract an otherwise unwarranted premium, as liability matchers and income investors rotate into equities as a substitute for fixed income. This valuation-insensitive buying has served to push up multiples on many low growth companies, arguably beyond levels that could be justified under other circumstances.
This scenario becomes self-perpetuating, as the inability of active stock-pickers to outperform prompts investors to switch into low cost index products. This serves to push up cross-sectional correlations and drive dispersion down, further reducing opportunities for hedge fund managers to outperform.
An increase in interest rates should allow this phenomenon to begin to unwind. Rising capital costs force greater selectiveness in capital allocation and eventually prompt companies with the weakest balance sheets to rationalise and restructure. The worst excesses of capital expenditure are revealed and capital markets will gradually close to the least creditworthy issuers. Rising capital costs therefore increase the dispersion of corporate results and, consequently, of stock prices.
Strategies that effectively hold a ‘short’ liquidity position clearly benefit when the value of that liquidity is slashed by massive rate cuts and the associated suppression of market volatility. To this extent, there is a direct link between interest rates and the performance of these strategies. It is therefore reasonable to expect some underperformance from many liquidity-providing strategies during periods of rising rates relative to their performance under a falling rate scenario. This would particularly be the case if rates were to rise steeply or unexpectedly (although this does not appear likely in the current hiking cycle). However, once rates have stabilised at a higher level, managers will be presented with more attractively-priced opportunities, making the longer-term performance potential of these strategies commensurately more attractive.
A positive environment for most hedge fund strategies
In summary, we take a broadly optimistic view of the prospects for hedge fund strategies in a higher interest rate environment. We would regard the US Federal Reserve raising rates as a ‘normalisation’ of policy that should in turn engender a normalisation of the market environment. This, we believe, should be helpful to most hedge fund strategies.
Whether or not the path to this rosy scenario is constructive for performance will be more dependent on a combination of the drivers of specific strategies, the means and timing of any shift in monetary policy and investor sentiment. History gives us a number of examples of poorly received interest rate increases which have derailed markets or triggered negative investor sentiment. However, once the US hiking cycle is established, we have reason to believe that the strategies discussed here will have opportunities to profitably exploit the resulting environment.
1 The benchmark US interest rate, as set by the Federal Open Market Committee.
2 Forecasts are not a reliable indicator of future performance.
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