There were plenty of winners from the ninth year of the historically long bull market in 2017, with the S&P 500 index returning 19% amid record low volatility. Perhaps one of the more surprising success stories of the year, though, was the hedge fund industry.
Despite the extended bull run, the HFRI Composite index recorded 12 individual months of positive returns for the first time since 2003, closing the year up 8.5%. While still well below the S&P, this marked the best annual performance for hedge funds since 2013.
This was not lost on investors either, as net inflows surged to $49.5 billion – a stark reversal of the waning confidence in 2016 that had prompted outflows of $109.8 billion.
John Frede, director of research with responsibility for hedge fund manager selection at 50 South Capital Advisors, said: ‘I was defending the hedge fund industry in 2016, but clients were much more receptive in 2017.’
He’s not wrong. According to Deutsche Bank’s 16th Annual Alternative Investment Survey, around half of investors plan to increase their hedge fund allocations over the next 12 months.
‘The hedge fund industry is now experiencing a renaissance,’ said Amy Bensted, Preqin's head of hedge fund products.
‘This may be largely due to an expected correction in equity markets. Half of investors now feel that the long bullish phase of recent years is close to ending – a sentiment seemingly confirmed by rising volatility in recent weeks. In these circumstances, hedge funds provide a valuable opportunity for portfolio diversification and downside risk protection.’
That’s the theory at least, but how did hedge funds and hedge fund strategies fare during the recent sell-off and the return of volatility?
The spike in volatility, driven by fears of higher inflation and rising interest rates, sent shockwaves through the markets globally. While hedge funds still declined, they were largely insulated from the steep losses seen across the broad equity indices.
‘We provided clients with 50% downside protection,’ said American Century’s Cleo Chang, portfolio manager of the AC Alternatives Long/Short Equity fund, a liquid alternative offering.
‘The strategy was able to mitigate the volatility by having a hedged portfolio, but also provided alpha from long/short European equity and technology specialists,’ she added.
Chang’s was not the only liquid alternative strategy to prove its worth during February’s bout of volatility.
‘Our models responded to the initial turbulence in markets by moving to a slightly more defensive stance,’ said Richard Mathieson, portfolio manager and managing director of BlackRock’s Systematic Active Equity division. ‘This was largely driven by a group of signals that track signs of rising distress and escalating liquidity risk, which can arise from aggressive deleveraging across this part of the market.’
Mark Jurish, executive vice president and head of hedge fund investing and seeding strategies at Fiera Capital, believes long/short strategies will continue to outperform over the whole of 2018, not just for one week in February.
‘Over the past few years, there have been massive flows into passive strategies, led by investments in the FANG growth stocks. That’s one of the reasons why we have witnessed such significant equity returns,’ he said.
‘With the return of volatility, these flows may have peaked, leading active managers to outperform, especially managers with a more balanced net long/short exposure,’ he added.
He also said that there were some other events on the horizon that should boost these managers further.
‘The combination of corporate tax reforms, deregulation and more repatriation of profits back into the US will create a huge cash surplus on corporate balance sheets, ultimately leading to more M&A and other activity,’ he said.