Can Policy Evolution Be A Shot In The Arm For Hedge Funds? by Marc Gamsin & Jeff M. Bennett, Alliance Bernstein
Hedge fund returns lagged during the multiyear rally in US equities, as capital markets rode a wave of unprecedented monetary easing. But the impact of policy changes could mean changing fortunes for alternatives.
After the global financial crisis, highly accommodative policies from the US Federal Reserve fostered an environment of low volatility, with few distinctions among security valuations. And the equity market rally was narrow, led by a group of large-cap stocks. This environment made even a passive approach of stocks and bonds highly effective. Beta, or exposure to broad market movements, ruled.
On the other side of the coin, strategies focused on outperforming through individual security selection, or alpha, faced stiff headwinds. Fundamentally driven hedge funds were among the approaches that struggled: they depend heavily on winning with alpha and tend to have less beta exposure, so they’re less responsive to broad market swings.
Let’s assume that the typical long/short hedge fund has a beta, or market sensitivity, of 0.5. If the equity market rises by 30%, you’d expect that hedge fund to rise by only half that much. So, it would produce only a 15% return from beta. The manager would need to rack up 15% from alpha just to make up the difference.
Alpha Has Shined as Policy Becomes Less Accommodative
Alpha generation has faced challenges in recent years, but that could change as US monetary policy evolves. Quantitative easing came off the books last October and the Fed raised short-term rates by 25 basis points in December.
There’s debate around the future path of rates, but policy has become incrementally less easy. Just as hedge funds tend to underperform stocks when the Federal Reserve is easing, they’re better equipped to outperform both stocks and bonds when policy becomes less easy. And hedge fund outperformance in these periods has come largely from alpha.
On average, the broad universe of hedge fund managers generated little alpha during periods of monetary easing. On the other hand, they produced 3.5% alpha in annualized terms during stable policy regimes and almost 10% during policy tightening (Display). This phenomenon seems to transcend hedge funds, applying to long-only active management, too.
Hedge Funds have fared better when Fed isn’t easing
Let’s look at some of the reasons why hedge funds could see better days.
Falling Correlations Amplify the Opportunity Set for Security Selection
Historically, the end of easing cycles also sees correlations among individual stock returns trend downward, creating greater distinctions that active managers can capitalize on. So does higher volatility, as market uncertainty creates more turbulence.
During easing cycles, markets tend to be narrow, with broad market indices driven by a few mega-cap issues. When only a small number of securities outperform, it’s harder for active managers to outperform through security selection. When the market becomes broader, typical after easing cycles, active managers have more targets.
Pricier Debt Reveals Distress—and Opportunity
Easy money policies historically drive down borrowing costs, which reduces the debt-interest burden for highly levered companies. Distressed debt managers and managers who focus on short selling are pressured; because debt-heavy firms have access to cheap capital market funding, they’re better able to stay afloat. This activity limits opportunities in distressed debt. With policies becoming less accommodative, that trend could reverse.
The availability of cheap debt during easing cycles also allows lower-quality companies with leveraged balance sheets to keep going by issuing debt at increasingly lower interest rates. Access to inexpensive financing reduces the opportunity for both equity and credit long/short and short-biased managers to create alpha by shorting companies that eventually go bankrupt.
The Impact of Better Short-Selling Opportunities
Think about it this way: A lofty goal for a long/short manager would be generating 10% alpha in a year. If only 5% of the companies a manager sells short go bankrupt and see their stocks decline to zero (a 100% profit to the hedge fund), then the manager is already halfway to that 10% alpha goal.
Short sales that fall to zero are almost nonexistent during easing cycles, but this scenario can change quickly during a rising-rate environment. The combination of growing interest expenses and thin operating margins can quickly lead to bankruptcy—even with only a modest decline in the company’s top-line sales revenue.
A Benefit of Higher Interest Rates
If interest rates begin to head higher, many hedge fund managers could see a direct positive impact on performance.
Managers using a macro approach, for example, tend to make heavy use of derivatives. As a result, they hold significant unencumbered cash balances, which benefit from higher rates. Long/short hedge fund managers typically receive a rebate from stock lenders when they short securities, and it’s based on prevailing interest rates. When rates are low, rebates are more of a drag on returns; when rates are rising, they provide a lift.
To sum it all up, passive market investments have flourished in recent years, but as we move into a period of likely stable or tightening Fed policy, investors face lower return potential. At the same time, fundamental factors suggest that hedge funds are poised for outperformance.
A move to active management seems to make sense today—and hedge funds are essentially the ultimate form of active management.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
