As the 10-Year Treasury Yield creeps higher and the Fed appears poised to stick with its “higher for longer” mantra, hedge funds are facing an important test. As of October 2023, it has not been a good year for stocks and it has been an awful year for bond holders.
Given this, it is little wonder many investors are feeling rather dour. Stocks and bonds are both underperforming—so what is left? Many institutional investors hope now is the time alternatives will deliver on their promise of low correlation to the stock and bond markets. And this is perhaps most true in the hedge fund space.
It has been a very mixed year for hedge funds as a group, with some like Citadel turning in impressive performance, but many others failing to keep pace. Market commentators and investment banks have consistently suggested that hedge funds may benefit from greater volatility and increased dispersion in the markets. Goldman, for instance, put out a note in August suggesting the time for hedge funds to shine is now.[1] They noted that alpha as generated by hedge funds over the last decade has been quite lackluster, but in 2023 showed signs of picking up. In the mid-2000s, hedge fund annual alpha generation averaged about 5% annually but fell to roughly 0% by 2019.
That type of performance—just matching the market but not actually generating any excess returns above risk—might have worked in a rising market environment. Still, it will be very hard for these firms to justify their fees if they can’t generate any alpha in a sideways to somewhat negative market environment such as what we have now. Why would any portfolio manager allocate to a fund that charges high fees, but just tracks the market? If hedge funds will prove their bonafides as a group, it must become apparent in the current market. Researchers have found that investment inflows disproportionally flow to those funds with strong recent performance, even if that performance does not seem to be sustainable.[2]
So what should hedge fund managers be doing today to try and capitalize on the opportunity in front of them? The answer is to live up to their reputation and marketing as low-correlation alternative investment strategies. Easier said than done, but those funds that have a disciplined and differentiated strategy rather than just an effective sales team, are more likely to have success.
Another option may be to lean more into automation and quantitative investing. A recent study found that hedge funds that rely more heavily on automation outperform by 50 bps per month compared with low-automation peers.[3] It seems AI may be good for more than just market hype after all.
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[2] See Baquero, G., & Verbeek, M. (2022). Hedge fund flows and performance streaks: How investors weigh information. Management Science, 68(6), 4151-4172.
[3] See: Grobys, K., Kolari, J. W., & Niang, J. (2022). Man versus machine: on artificial intelligence and hedge funds performance. Applied Economics, 54(40), 4632-4646.