The collapse in volatility and yield might be the main culprits. Volatility neared the mid-90’s all time lows in 2014 as a result of a combination of factors. The unprecedented global monetary reflation was undoubtedly the most powerful one. Subject to growing risks constraints and a positive correlation between equity and bonds, hedge funds only partially benefitted from the asset reflation which unfolded since the financial crisis. Meanwhile the plunge in volatility and asset dispersion shrunk the potential for alpha generation. The authors emphasise that the Volatility/Correlation/Dispersion regimes are key hedge fund return factors. For instance, a low volatility environment is negative for alpha generation and this has hurt hedge fund performance during the time the Fed has tamed volatility with its QE programme. One response of the hedge fund industry was to significantly lower both management and performance fees.
In the 12th edition of the White Paper, the authors evaluate the drivers of hedge fund returns. The authors test their structural exposures under 3 macro-economic scenarios over the next five years. Using conservative assumptions, the authors estimate that hedge funds could deliver annual excess returns in the 5-6 per cent range over the Libor 3M, with lower volatility than that of risky assets. In order to reach these expected returns, hedge funds would have to deliver alpha in the range of 3-4 per cent per year, the rest being market beta. The authors make several scenarios for market developments and their influence on hedge fund returns and found that a scenario in which the Fed tightens faster than expected by the market would boost hedge fund returns. Meanwhile a scenario in which the US economy would face secular stagnation, leading to continued monetary easing would be the less supportive.
The authors believe that diversifying portfolios with an increased allocation to alternatives is particularly attractive at this stage of the cycle. Hedge funds have demonstrated their ability to protect portfolios against wide market fluctuations, a scenario that the authors cannot exclude when the Fed turns the screw.
Full White paper: A New Era For Hedge Funds
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