Hedge funds have been a major force across the industry since the 1990s, attracting millions from investors. However, in recent history, the sector has underperformed its benchmarks on an average basis.
"The low interest rate and low inflation environment we had experienced for the previous decade or so led to relatively low market volatility and therefore less opportunity for hedge fund traders," said Robin Willis, co-manager of the Premier Miton Defensive Growth fund.
However, the tide appeared to turn in 2022, as some strategies achieved positive returns while the main stock and bond indices plunged. Looking at investment trusts alone, the IT hedge funds sector returned 0.2% in the last year, while IT global lost 4.4%, according to data from FE fundinfo.
Given their aim to provide lowly correlated returns, some analysts have said hedge funds proved their value proposition last year.
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"Higher levels of inflation and tightening of monetary policy by central banks have reversed this trend and led to strong returns for global macro strategies at a time when investors were getting little diversification benefits from bonds as equity markets fell," Willis said.
Looking to 2023, Mark Dowding, CIO at RBC BlueBay Asset Management, said markets need to be prepared for an economic outlook where growth is firmer, labour markets more resilient and core inflation more sticky.
"This will require more from the Federal Reserve than is currently priced into rates markets and more tightening from the Fed, which will be problematic for global financial assets," he explained.
While the outlook for equities remains challenging, Aviva Investors' multi-asset team is still favouring hedge funds and other liquid alternative strategies, which portfolio manager Harriet Ballard previously told Investment Week are "well placed" to take advantage of global macro trends and short-term trading opportunities.
Strategies
Most hedge funds may have a risk profile that is comparable to, or even lower than, the typical long-only fund, but some employ aggressive strategies and can take on significant risk while pursuing high returns.
As the sector encompasses a wide range of objectives and strategies, it is important for investors to understand the specific hedge fund they want to invest in.
Using a multi-asset perspective, Willis said he tries to identify strategies that provide positive returns with less than a quarter of the volatility of equities.
"We therefore avoid highly leveraged, concentrated, activist-type equity strategies and consider funds with more of a capital preservation bias, such as global macro and relative value strategies," he said.
Angela Xu, investment analyst at SECOR Asset Management, pointed to catastrophe reinsurance, a hedge fund strategy that invests in catastrophe bonds and has almost no correlation to the stock or bond markets.
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Significant institutional capital flowing into the strategy, combined with above-expected claims, has resulted in "mediocre" returns over the past six years, according to Xu, with 2022 a standout example.
However, Xu noted that as it stands for the 2023 renewal season, total industry capital is at its lowest in nominal terms since 2013, while average premiums are at their highest levels since 2006.
"All else being equal, if in 2023 the weather is better and premiums remain strong, then there is the potential to make the case for catastrophe reinsurance," she added.
Meanwhile, Xu said the more traditional long-biased or moderate net long/short equity strategies look far less interesting, particularly for growth-oriented funds.
"Overall, difficult industry dynamics, coupled with a regime change in the underlying asset class, makes for a risky proposition for moderate net to long-biased growth funds in the coming year," she said.
Fund picks
For those investors looking to gain exposure to the asset class, Evelyn Partners' head of multi-asset funds Ben Seager-Scott pointed to three strong candidates for portfolios.
Marble Bar's long/short equity fund Chelodina was selected as a contender due to its tendency for market neutrality, providing good diversification characteristics with a strong multi-PM approach and dynamic strategy allocation, he said.
Another fund pick was CIFC Long/Short Credit, which takes a flexible approach to relatively low net exposures that "gives plenty of scope to add value to investors", he said, while maintaining diversification within a multi-asset portfolio.
Finally, Seager-Scott highlighted Mygale Event Driven, a European-focused hedge fund that seeks to take advantage of event-driven market inefficiencies, particularly in the small- and mid-cap space, where "attractive opportunities" can arise, he said.
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While there is a broad range on offer, Willis said the hedge fund industry is "notorious" for charging high management and performance fees.
"However, after falls in bond and equity markets in 2022, it is likely investors will be prepared to pay more for access to a manager delivering a genuinely differentiated return profile," he added.
Premier Miton's multi-asset team has tended to gain exposure via listed hedge funds, which Willis said meant they are not restricted by quarterly redemption periods and can buy and sell shares as they wish, although within the confines of trading liquidity.
"Another alternative method we have employed to gain exposure to hedge fund strategies is through passive investments," he added. "These investments look to replicate hedge fund strategies in a liquid and low-cost manner through a systematic, rules-based approach."