Are Hedge Funds on the Verge of a New Era?

Are Hedge Funds on the Verge of a New Era?Despite its outstanding track record over the past several decades, the hedge fund industry has come under mounting pressure more recently. With the exception of last year and the brief euro-crisis period, hedge fund returns have lagged stocks and bonds since the Financial Crisis, and as a result, hedge fund managers have had to lower fees to keep their inflows robust. But Lyxor Research thinks the factors that have led to hedge-fund underperformance are about to change, and asks, “Are we on the verge of A New Era For Hedge Funds?

The paper – which was authored by Lyxor’s Senior Cross Asset Strategists Phillipe Ferreira and Jean-Baptiste Berthon, along with Global Head of Cross Asset Research Jeanne Asseraf-Bitton and CIO of Alternative Investments Jean-Marc Stenger – explores the following questions:

  • What factors have led to hedge funds’ underperformance since the Financial Crisis?
  • Will those factors persist, or is there evidence they’re about to change?
  • What is the outlook for hedge fund returns going forward?

Why Have Hedge Funds Underperformed?

Lyxor cites the following as three important reasons hedge funds have lagged the broad stock and bond markets since 2009:

  • Unprecedented monetary policies;
  • The resulting excess liquidity; and
  • New regulations.

The Federal Reserve’s quantitative easing (“QE”) involved expanding the U.S. money supply to buy bonds and other assets, thereby pushing down interest rates. This lowered the risk-free rate of return.

QE also resulted in “liquidity-driven markets,” according to Lyxor, boosting the returns of virtually all stocks and bonds. As a result, dispersion between the best and worst performers was reduced, and this hurt hedge funds’ ability to generate alpha.

At the same time, post-Financial Crisis regulations hamstrung hedge funds. Lyxor goes so far as to say that Dodd-Frank have had a bigger negative impact on the hedge fund industry than any other segment of the financial sector.

Are These Factors About to Change?

But at present, things are on the verge of changing. The Federal Reserve, which ended its QE program on Halloween 2014, seems intent on raising interest rates sometime this year, and a return to monetary-policy normalcy could result in extraordinary volatility, if history can be any guide. This is precisely the environment in which many hedge fund strategies outperform – especially in relation to long-only stock and bond portfolios. According to Lyxor, alpha generation has already been on the rise since mid-2014.

Longer-term, a less accommodative policy from the Fed should allow for greater differentiation between the best and worst stocks and bonds. When low interest rates are causing virtually everything to go up, it’s much more difficult for a hedge fund – especially long/short funds – to outperform. A rising tide may indeed lift all boats, but it also naturally causes hedge funds to lag.

Outlook for Hedge Funds

Ultimately, Lyxor believes evidence that an abrupt reversal of the conditions that have led to hedge fund underperformance is multiplying. As a result, the firm projects hedge funds should generate excess returns of 5-6% annually, with low volatility, going forward – and Lyxor says these estimates are based on “conservative assumptions.”

While hedge funds have underperformed in recent years, their longer-term track record is “outstanding,” in Lyxor’s view, and their recent underperformance could indicate a good buying opportunity. “We believe that diversifying portfolios with an increased allocation to alternatives is particularly attractive at this point in the cycle,” the paper’s authors write. “Hedge funds have demonstrated their ability to protect portfolios against wide market fluctuations, a scenario that we cannot exclude as the Fed turns the screw.”

For more information, download a pdf copy of the white paper.

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