Hedge Fund Investors Respond to the Turning of the Business Cycle

Hedge Fund Investors Respond to the Turning of the Business Cycle

It is reasonable to expect that a diversified hedge fund portfolio will make more modest returns in 2020 than it did in 2019, according to Agecroft Partners, which has done its usual January crystal-ball gazing on the new year, looking for the top industry trends and how they may play out.

Hedge fund performance, Agecroft reminds us, has beta (market) and alpha (managerial skill) components. Over the past 11 years both the fixed-income and the equity markets have performed so well (coming off the deep lows of 2009) that the beta has rewarded managers just for being long.

Worrisomely High Equity Prices and other Portents

But now, with equity prices at worrisomely high levels, and with central bankers preserving a historically low-interest-rate environment status quo, it is difficult to see much room for further beta-driven gains. Assuming a constant level of skill, this will depress the industry average performance.

On the other hand, the same factors may lead investors, within the set of those previously satisfied with long-only managers, to look for more adventurous strategies, letting hedge fund managers woo them away. In part for this reason, Agecroft also expects that hedge fund industry assets will increase through 2020, reaching a new all-time high.

That won’t necessarily mean an increase in net revenue for the managers, though. Agecroft expects a continued decline in the fees charged due to competitive pressure, and the effects of the fee decline may overcome the effects of the asset growth.

Meanwhile, late-cycle concerns on the part of investors will likely generate some rotation of strategies within the hedge fund world.

Strategies, Structures, Asset Classes

Indeed, Agecroft sets out the hedge fund strategies that it believes will be the winners of this shift from an expectation of continued growth to an acceptance of the premise that we are at the top of the business cycle already. Commodity Trading Advisors (CTAs) will gain, as will long/short equity managers with a proper focus (more below on this), relative value fixed income strategies, and strategies that blur the line between private equity and hedge funds.

These PE/HF line blurring funds are generally in private lending/specialty financing. Agecroft says that they “offer an attractive alternative to traditional fixed income, though there is a growing concern about how they will perform in a market downturn.”

The report also briefly alludes to changes in the way institutional investors think about research. Ten years ago, the institutions generally divided their research teams by fund structure, working with fixed income, hedge funds, and private equity teams. Now they are much more likely to use an endowment model approach, which entails dividing the work by asset class. This contributes to the blurring of the line between hedge funds and private equities.

Black Swans in the Persian Gulf

The Agecroft report was prepared before a recent Black Swan event—the targeted killing of Qassem Soleimani by a US drone strike and the Iranian reaction, missiles fired at a US Air Force base in western Iraq. The event may help strengthen the case for some of the points in the report. When war breaks out, especially in the Middle East, investors look to safe havens and fund managers think about risk management.

In a recent posting in Seeking Alpha, “Heisenberg” does an impressive job addressing this point. He juxtaposes the Global Economic Policy Uncertainty Index, which he calls a news-based measure of policy and political uncertainty, with the recent history of the VIX, which is how the market measures risk/uncertainty.

The point of the juxtaposition is that two understandings of uncertainty don’t track each other. The great rise and fall of VIX through the period 2007-09 had no Global EPU analog. On the other hand, the steady rise in Global EPU through the years 2018-19 had no VIX analog.

But the drone strike against Soleimani, and reactions to that, may have the effect of bringing the two meanings of uncertainty together again. This is a good moment to be looking for hedging strategies at a time when central banks have used up their ammunition and safe havens are becoming scarce.

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