Investment manager Neuberger Berman in their recent report point out that a rising interest rate environment would be ultimately constructive for long/short equity hedge funds.

Neuberger Berman in their report titled: “2014 Hedge Fund-Strategy Outlook” notes discretionary global macro managers are better suited to generate profits in the current policy-driven market environment.

Constructive on long/short equity in 2014

The report notes the recent trends of lower stock correlations and higher valuation dispersion will continue, aided by a higher interest rate environment over the medium term. The investment manager believes this should prove beneficial to the ability of long/short equity funds to generate alpha.

The report also foresees an environment of positive economic growth, higher levels of corporate activity, rising interest rates and increasing differentiation in stock valuations to provide additional tailwinds for the strategy going forward. However, the report points out that in the event of a pullback, the meaningful short exposure of a typical long/short equity fund should help minimize downside participation.

The report suggests investors should have a meaningful allocation to long/short equity in 2014.

As highlighted in the following graph, the ability of long/short equity hedge funds to outperform the market (adjusted for the average long/short hedge fund net exposure) is tied to the level of valuation dispersion in the equity markets:

Valuation dispersion Vs Outperformance Long Short Equity

Attractive opportunities in macro-focused investing space

The report points out that niche macro-focused investment opportunities such as co-investment opportunities with commodity-focused managers are appealing. The report suggests one can benefit from monitoring and evaluating a large number of funds across all sleeves of the macro-focused investment space.

Though the macro-focused investing space presents attractive opportunity for investors, the report suggests a careful evaluation and selection at both the sub-strategy and individual manager levels.

Structured credit still offers value

Neuberger Berman in their report note structured credit still justifies a material allocation in portfolios. However the report favors managers who can invest outside of the plain vanilla non-agency RMBS/CMBS and CLO space such as reg cap or TARP preferred securities.

The following graph demonstrates the structured credit spreads:

Structured credit spreads

Diversify across hedge fund strategies

The report highlights the rising interest rate environment through the second and third quarters of 2013 was particularly painful for long-only fixed income investors with long duration portfolios, and is likely only a glimpse of what is to come. However, the report notes hedge funds have the potential to protect capital and often benefit from rising rates and hence makes them an attractive complement to traditional allocations for a variety of investors.

The report suggests by diversifying across hedge fund strategies and building a conservatively positioned portfolio with a robust short book and modest gross and net exposures, investors can achieve absolute returns and a low beta to the broader markets during these challenging times.

The following graph highlights portfolio performance during rising 10-year treasury rates and 90-day T-Bill rates:

Portfolio performance