Hedge funds are expected to again outperform their historical average return in 2014, notes Deutsche in its recent research report.

Tim Gascoigne and Claudia Roering of Deutsche while reviewing the performance of 2013 point out the US equity market enjoyed a strong year in 2013. It posted almost 30% during 2013, though its performance was eclipsed by the Japanese market posting over 50% rise.

Hedge Funds’ another solid performance

The Deutsche analysts believe hedge funds should be able to deliver another solid performance in 2014, with a number of sectors likely to be particularly well suited to the market environment.

The Deutsche analysts anticipate equity long/short will perform well in 2014 backed by their expectations of steady gains for equities and a helpful environment for stock-pickers, particularly as progress on tapering is priced into markets during the year.

The analysts believe equity markets in the US will reflect company fortunes rather than macro and political influences. The analysts have a similar outlook for Europe, where the tail risk of a Eurozone unwind has diminished. The analysts anticipate more selective opportunities in emerging markets driven by individual country risk.

The analysts are also overweight on equity market neutral, as they believe both factor-driven and statistical arbitrage managers should receive tailwinds in 2014.  The analysts believe factor-driven approaches should benefit from the improved stock-picking environment, as well as an increased focus on style and valuation factors by investors in more stable markets.

The following table captures summary of the Deutsche analysts’ hedge fund outlook:

Hedge fund outlook-summary

Underweight on distressed

However, the Deutsche analysts believe the dearth of bankruptcies in both current and expected will drag returns for managers in the distressed sector throughout 2014. The analysts point out that with default rates currently at a historically low level of 2.2% as against an average of 4.9%, the forecasts suggest they will remain muted throughout 2014.

Considering the above aspects in mind, the analysts have come out with the following balanced hedge fund portfolio, including desired allocations for various strategies:

Balanced portfolio

The Deutsche analysts, however, point out that the outlook outlined above is predicated by their anticipation that (a) global growth will accelerate above consensus, driven by a consumer recovery in the US and Europe, (b) China’s economy will hold up well, (c) The USD will be supported by a clearer demarcation in policy between the Federal Reserve and the European Central Bank and (d) Market participants in developed markets will respond relatively benignly to Fed tapering.