Evening Brief – 10.18.23

Hedge Fund Investors Want More Returns

Investors now want nearly 3% more in returns from their hedge fund holdings. Nearly half of investors will change their strategy allocation to take advantage of higher-for-longer interest rates, according to new BNP Paribas research.

The research comes as hedge funds and other alternative asset managers attempt to navigate an increasingly difficult investment landscape driven by rising interest rates, which has seen bonds and equities upended amid greater volatility in recent weeks.

The Capital Introduction Group at BNP Paribas polled 34 hedge fund managers and 48 hedge fund investors on how they are preparing for a higher rate landscape, with the study looking at how the new environment would affect hedge fund performance and terms.

In response to rising interest rates, investors upped the return target of their hedge fund portfolio by 2.9%, to 9.75% from a 6.85% annual return target.

Nearly two-thirds (62%) of hedge funds believe their strategies will beat the risk-free rate by 6% or more, with managers citing increases in volatility and dispersion as a key driver of investing opportunities.

However, managers warned of potential negative consequences of higher rates, such as increasing financing costs, shorts becoming more expensive, and potential deleveraging among systematic and hedge participants during volatility and drawdown periods.

BNP’s research indicated that investors are split on whether to alter their hedge fund strategy selection: although 48% of investor respondents are already reworking their exposures due to rate hikes, 52% are standing pat.

In the face of rising interest rates, over 64% of investors want to increase their exposure to credit hedge fund strategies, while only 12% intend to decrease their exposure. About 32% intend to raise their CTA and trend-following exposure, while 32% intend to increase their discretionary macro exposure, and 8% intend to decrease their allocations to each. While 40% of investors aim to increase their investments in long/short equity managers, nearly a quarter (24%) intend to reduce their holdings.

While multi-strategy hedge funds have dominated the news in 2023, more investors (32%) want to limit their exposure than increase their allocations (20%).

“This seems a contrarian or an inflection point to break the last two-year trend where multi-strategy are in vogue,” BNP noted in the report. “This could be due to the fact that investors view these allocations for a longer period; this could be attributed to the fact that investors are satisfied with existing allocations and are also looking to redeem from some due to muted performance.”

The study found that hedge funds typically outperform in high-rate environments but underperform in low-rate regimes.

Hedge funds produced an average beta-adjusted annual return of 6.38% between 2000 and 2008, compared to 3.24% for short-term rates. During the previous 13-year low-rate period, hedge funds delivered an annual beta-adjusted return of 1.40%.

However, BNP cautioned that in the past, hedge funds have failed to adjust quickly enough in the face of rising interest rates, resulting in a lag in providing better returns, as seen in 2006. As interest rates stabilized at higher levels, as they did in 2007, hedge funds were able to successfully manage the new environment and provide strong beta-adjusted returns.