Challenging portfolio dynamics, plus an environment ripe for potential alpha generation, have placed renewed emphasis on hedge funds as an option for investors seeking diversification.
Key Takeaways
- Some investors are placing renewed emphasis on hedge funds amid recent challenges to the traditional 60/40 portfolio.
- Rising volatility and higher interest rates may position hedge funds to perform well.
- Among the various hedge fund strategies, investors can consider multi-PM hedge funds, which use a centralized risk-management function and harness the powers of diversification to potentially generate consistent returns.
Hedge funds are garnering renewed interest as institutional and high-net-worth investors reconsider ways to diversify their portfolios. In the last few years, the traditional portfolio mix of 60% stocks and 40% bonds, which used to offer a robust level of diversification,1 has been challenged as inflation and rising interest rates have made stocks and bonds move in tandem—leaving investors looking for other options.
Hedge funds, which reached a record $5.2 trillion in assets in the third quarter of 2024,2 may be poised to perform well in a market environment of higher interest rates, volatility and uncertainty about traditional markets. Morgan Stanley Investment Management Hedge Fund Solutions Chief Investment Officer Mark van der Zwan explains the macroeconomic factors contributing to his outlook on hedge funds and what strategies he finds particularly compelling in today’s market environment.
Q: Why should investors consider hedge funds as part of their portfolios?
A: Hedge funds are alternative investments that aim to provide a source of diversification3 within portfolios, offering returns that are not correlated with other investments. Hedge funds aim to generate alpha, or excess return above benchmarks that the investments are being measured against. The returns often differ significantly from the results generated by traditional investments in asset classes like stocks and bonds. Hedge funds are unconstrained in their investment style, which, among other things allows them to profit from both long (buying with the expectation that the asset will increase in value) and short (selling an asset not owned with the expectation to buy it back at a lower price) positions. This capability allows hedge funds to potentially offer investors positive returns regardless of whether the market is rising or falling, providing a source of returns that does not rely heavily on broad market movements.
It’s important to underscore that there is a lot of variety among hedge funds. The category encompasses diverse strategies that invest in various asset classes, using different investment techniques. Each hedge fund strategy has a distinct objective and profile, and investors should aim to match their desired outcome with the hedge fund’s investment objectives.
The shift toward an environment with a greater range of prices across and within asset classes, plus periods of heightened volatility, have created an environment ripe for hedge funds to potentially deliver attractive levels of skill-based returns.
Q: What makes hedge funds compelling in today's market environment?
A: Hedge funds are more relevant than ever. For many years, investors relied on traditional fixed income to hedge equity risk. In 2022, we saw fixed income decline in tandem with equity markets. This prompted investors to search for alternative sources of diversification, such as hedge funds. Additionally, there is more opportunity for hedge fund alpha generation. The shift toward an environment with a greater range of prices both across and within asset classes, plus periods of heightened volatility, have created an environment ripe for hedge funds to potentially deliver attractive levels of skill-based returns.
Q: How does the current interest rate environment affect your outlook for hedge funds?
A: Higher interest rates can directly and indirectly help hedge funds. They directly benefit from the higher yield environment, through potentially enhanced returns on unencumbered cash (liquid assets that are not pledged as collateral for debts or other obligations) and an increased short rebate (interest on cash held as collateral for short sales less any dividends received during the loan period). Indirectly, higher interest rates have historically corresponded with periods of greater price dispersion among assets. This offers more opportunities for hedge funds to capitalize on asset movements and deliver alpha to investors.
The chart below highlights that higher Federal Funds rates have translated into higher monthly hedge fund returns across all main sectors.
Hedge Fund Returns Improve with Higher Rates
Although the Federal Reserve has begun to cut interest rates, we still expect the peak rate to be at a level much higher than we saw in the 2010s, which may continue to provide a supportive environment for hedge funds.
Q: Are there specific hedge fund strategies or structures that are particularly attractive right now?
A: Multi-PM platform hedge funds are very compelling for potential returns and diversification. They use many specialized portfolio managers collectively operating as one entity, with a centralized risk-management function. Each portfolio manager is tasked with running a specific, specialized strategy within certain risk-management guidelines, which are enforced by the central risk function. By enforcing low correlation between their portfolio managers and reducing unwanted exposures, these platforms can harness the full benefits of diversification and can be a very efficient method to deliver skill-based returns.
