Lyxor Research published a report titled A New Era for Hedge Funds? earlier this week. The report highlights that while hedge funds have underperformed traditional asset classes during the last few year, there is good reason to think the worm is turning.
Although hedge funds can boast of a strong record track record over recent decades, the industry has been pressured to make changes for the last couple of years. Notably, inflows into the sector remain steady, but keep in mind that hedge funds have reduced both management and performance fees as a result of the changing environment.
Philippe Ferreira and the rest of the Lyxor team take a closer look at the main drivers of hedge fund returns and come to the conclusion “that the normalization of US monetary policy and US equities’ loss of momentum will lead to HF outperformance versus traditional asset classes. We expect annual excess returns in the 5-6% range.”
Pinpointing the problem with hedge funds
The chart makes it clear that hedge funds have provided lower returns than stocks and bonds for more than six years. Since early 2009, global stocks have given compound annual returns around 18% per year (in total return) while hedge funds have produced compound returns under 8%. Of interest, a portfolio of equities and bonds (60/40) has also produced notably higher returns of 12.7% annually.
Ferreira and colleagues argue that the drop off in bond yields following the Fed’s QE has had a major negative impact on hedge fund performance. They also point out that equity beta has decreased while stock markets moved up, and alpha generation is off due to the low volatility and low dispersion environment.
The Lyxor team extends their argument and notes: “However, alpha generation has started to rise since mid-2014 and the environment is now improving, with valuations stretched across the board, the economic cycle maturing and the Fed beginning to normalise monetary policy.”
Forecasting the future
Looking forward with conservative assumptions, Ferreira et al. anticipate that hedge funds will deliver annual returns in the 5-6% range with low volatility for the next several years. They conclude: “We believe that diversifying portfolios with an increased allocation to alternatives is particularly attractive at this point in the cycle. 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.”
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