Hedge funds are having to adapt to a radically different market environment this year. For some, life has become much tougher. But for others, these are precisely the conditions they have long been waiting for.
A new world of high inflation, sharply rising interest rates and rapid quantitative tightening, almost unimaginable just a few years ago, has upended equity and bond markets over the past six months. Eurozone inflation this week hit another record high of 8.1 per cent, increasing pressure on the European Central Bank to speed up rate increases.
High-growth technology stocks have been particularly hard hit. While they can soar to enormous valuations when interest rates are near zero, higher rates mean their prospective future profits look relatively less attractive. Tiger Global and some of the other “Tiger cub” hedge funds that prospered during the bull market have felt the full force of this sell-off, in some cases losing much more than the wider market.
But for some managers who focus on exploiting price discrepancies between stocks, conditions are now in their favour. They had been left frustrated by the “everything rally” in which investors often appeared unconcerned about whether they were buying a high- or low-quality company. However, the removal of the ultra-low-cost financing that was long available to companies is starting to separate the wheat from the chaff.
“Market neutral [equity] and low net funds should benefit from stocks . . . reflecting fundamentals now,” said Kier Boley, chief investment officer of alternative investment solutions at UBP, referring to funds that try to make money from weighing one stock against another, rather than predominantly from betting on rising prices.
A perfect example of how conditions have changed for such funds is London-based Sandbar Asset Management. A year ago, I wrote in this column that the firm with $2.2bn in assets, founded by former Millennium trader Michael Cowley, was struggling with the seemingly illogical way in which markets were operating.
For instance, the correlation between an improvement in expectations about a company’s earnings and the reaction in its share price, which intuitively should be positive, had fallen “to levels not seen in the last decade”, Sandbar said at the time. In some sectors such as aerospace, it had even turned negative, meaning improving earnings expectations would actually push a share price lower. Sandbar ended the year down 7.5 per cent.
Much has changed since then. The fund is up 6.7 per cent in the first four months of this year, compared with a 7.3 per cent fall in equity hedge funds on average, according to data group HFR, and a 14.5 per cent drop in the S&P 500 index as of Wednesday.
Significantly, so-called alpha — industry jargon for the money a manager makes from their skill rather than simply from following overall market moves — has been positive for the fund for each of the past four months.
A major reason, according to Sandbar, is the fact that markets have now entered the “latter stages of the economic cycle”. It wrote in a letter to investors that this has historically represented a time when conditions have been most supportive for funds like itself. This was because “dispersion [between stocks] increases significantly” while returns from simply following the market moderate or turn negative.
The unwinding of positions by other investors at the end of last year and early this year as the market fell created opportunities for Sandbar to profit in recent months, it added.
While the outlook for such managers has improved markedly, there are still factors that could yet hinder their progress. Stocks have rallied over the past couple of weeks on hopes that bad news on the economy will persuade central bankers to limit interest rate rises. And, as UBP’s Boley points out, even if a manager gets the analysis of a stock’s fundamentals correct, their positions can still be knocked off course by a major investor unwinding its book.
Nevertheless, this sifting of the industry, which has long been forecast but often delayed by years of central bank stimulus, is being welcomed by many.
Hedge funds have struggled for much of the past decade to justify why investors should pay their high fees when returns were often uninspiring compared with index-tracking funds — available at a fraction of the cost — or compared with the profits apparently on offer from private equity funds.
In a world in which returns from stocks and bonds are now less appealing, hedge funds that do not simply try to ride the markets but instead exploit market dislocations may finally have hit their stride.