Hedge funds

Most HF indices registered just under a third of the decline experienced in equity markets during the COVID-19 sell-off in Q1 2020, with performance dispersion among managers widening significantly during the crisis. While growth and liquidity sensitive strategies suffered from a disruption in market functioning due to a significant deterioration in market liquidity, defensive strategies were able to limit declines to the low single digits. Participation in the subsequent rebound has been in line with historical trends and, on aggregate, hedge funds have fulfilled their role of portfolio stabilizers, delivering a small positive performance in the first nine months of 2020. Although HF returns have been on a declining trend in recent years, we expect them to stabilize at low single-digit levels as the economic recovery continues and trading conditions improve. Importantly, we expect hedge fund volatility to be comparable to IG bonds in the USA or UK, making them a viable alternative in helping to balance risk and return in multi-asset portfolios. In contrast, government bonds face negative total return prospects, while other options to improve portfolio stability are either more illiquid (e.g. infrastructure) or may be too complex to be implemented by private investors (e.g. option overlay strategies). Recent surveys have shown that investor interest in HFs is growing, including one conducted by Preqin in H2 2020.

Conducive environment in 2021

HFs are set to enter 2021 amid more favorable conditions than in 2020. First, the COVID-19 crisis has led to a fundamental change in the outlook for several sectors. For example, it has increased healthcare spending and acted as a catalyst for positive technology trends that are likely to persist, while other sectors such as consumer discretionary will only experience a gradual recovery. Such divergences led to a conducive environment for stock picking and relative value trades. Second, we expect elevated market volatility to persist with increased trading ranges, which should help increase returns of tactically oriented HFs with skilled managers. Finally, relative value strategies can benefit from higher carry in non-traditional but fundamentally stable markets, such as mortgage-backed securities or consumer loans. Central bank asset purchases should guarantee smooth market functioning, thereby reducing liquidity risks. We think that a well-selected basket of HFs diversified across styles offers a good balance between expected return and risk, supported by the economic recovery and an improved opportunity set post the COVID-19 shock. As dispersion among managers and strategies has been wide, specialized due diligence is critical.

With sustainability and environmental, social and governance (ESG) compliance gaining more prominence in security selection and performance, managers with a robust ESG screening framework may fare better. While a fund of funds approach should enable portfolio diversification and stability for risk averse investors, a more targeted approach with allocations to top-performing managers holds merit for more risk tolerant investors to enhance return prospects.