It’s been a tough decade for hedge funds.
Record levels of stimulus have been pumped out by central banks, which have inflated bond and equity markets. Riding this momentum was cheap during this time – all you needed was an ETF. There simply was no need to chase alpha. That is until now.
The risks of holding an index are more apparent now. Stocks are expensive and investors want a more diverse range of risk-adjusted returns to protect their portfolios. Subsequently, hedge funds are back in fashion and active investing is in vogue.
The hedge fund industry this year has seen their assets swell to a record $4.3 trillion according to BarclayHedge. But first things first, what are hedge funds?
What is a hedge fund?
The word “hedge fund” is just a fancy name that includes a wide range of investment strategies. With a hedge fund, the portfolio manager is free to invest more aggressively in a greater set of opportunities than a traditional investment fund.
The reason why investors allocate to hedge funds is because their portfolio managers believe they can offer access to something called alpha. Alpha is simply the excess returns earned over an index.
As mentioned, searching for alpha hasn’t been a priority for most investors over the last 10 years because central banks have pumped huge amounts of liquidity into the market, which accelerated during the pandemic. There was little reason to pursue alpha at a greater cost so the passive investment industry swelled in size.
However, the US Federal Reserve is now drawing up plans to taper its asset purchases, which will remove some of the steam from markets and encourage investors to search harder for future returns. This has created renewed interest in hedge funds as they have been able to deliver solid performance over the pandemic and during the subsequent recovery.
Hedge funds are not an asset class
They represent a huge collection of strategies that try to earn a particular type of risk premium for their investors. There are so many different types of strategies that fall under the term “hedge fund”.
There are long-short equity strategies and market neutral strategies. Merger arbitrage is another strategy that can be pursued – it invests into the stocks of two companies that are about to merge. Then there are convertible arbitrage strategies, which by the convertible bonds issued by a company in the hope of realising a return. There are also global macro strategies, event-driven strategies, fixed-income arbitrage strategies and capital structure arbitrage strategies.
Each hedge fund, through its pursuit of alpha, offers investors a unique form of equity premium – a type of risk an investor will take to earn a return.
These different sources of equity premium when combined bring added diversity to a portfolio.
Hedge funds are investing in some interesting areas
Hedge funds are paid to have conviction and so they will invest in a diverse range of businesses, some of which are extremely interesting. They will also move across both public and private markets defined the best opportunities.
This could be for instance, a fashion incubator or a retail technology platform. In short, they may pursue opportunities that other traditional portfolio managers would shy away from because they have a lot of freedom and are generally unconstrained when pursuing an opportunity.
One interesting trend is the large range of tech-focused hedge funds that have emerged recently. These hedge funds benefited from the pandemic-induced lockdowns we experienced last year, which saw earnings rise due to a work-from-home trend that drove technology purchases. Demand for technology remain strong even after these lockdowns have ended, which reflects a much longer-term trend towards a future technologically-driven economy.
Another example of hedge fund flexibility is the way hedge funds can quickly and tactically tilt towards a certain sector. During the pandemic the stay-at-home culture led to increased savings. People couldn’t splash out on high-end holidays, restaurants and flights. Many hedge funds therefore tactically invested in the luxury goods sector which benefited from this large increase in savings over this period.
This is the attraction that investors feel now about the hedge fund industry. It offers a diverse range of investment opportunities that hedge fund managers can follow. When you look at the economic climate we are in, it’s no wonder why hedge funds are back in fashion.