The discovery of hedge funds (HF) as investment vehicles, free from regulatory constraints on portfolio choices and therefore favored by the best talents in asset management, took place over half a century ago. Since then they have experienced ups and downs in the performance and preferences of savers and intermediaries. Since they were not subject to regulation, they could not be offered to the public and have long remained reserved for a small group of professional investors. But the very good debut meant that at the end of the 80s institutional interest in HF was born and therefore the first sector indices were also developed.
La reputation of HF has grown thanks to those extraordinary results, especially of the Macro and Long/Short strategies that dominate the sector, much superior to the market and those of a balanced portfolio, but without recording higher volatility.
It is important to note that between 1990 and 2008 i interest rates short on the US dollar were on average 4,2%. The global banking crisis of 2007-8 radically changed the scenario. From 2008 to 2021, average short rates on the US dollar were just 0,5%. The practically zero rates have pushed the stock markets upwards, and the stock indices have even increased fivefold from the lows of 2009. A performance, therefore, in this second period largely superior to that of the HF, which has led investors to move away from these liquid alternative investments, which also continued to provide competitive returns compared to a balanced portfolio of similar risk.
The impact of interest rates on hedge funds
From 2022, monetary policies are normalizing, forced as they have been to chase the flare-ups ofinflation caused by bottlenecks in global value chains, the lifting of the lockdown and the consequences of Russian military aggression in Ukraine on energy and food prices. But how come the level of interest rates influence so much i results of HF and why does their normalization make us optimistic about the ability of HF in the future to justify the higher management cost that those who invest in them bear? They can be identified four main reasons:
- First of all, high rates make the stock market more selective.
- Then high rates mean that the liquidity generated in HF portfolios by short sales is better remunerated.
- Furthermore, high interest rates are normally associated with greater variability in macroeconomic and market conditions, creating more opportunities for "Macro" managers.
- Finally, the trend towards indexing, which has dominated market flows for the last quarter century, has likely run its course and will be less influential in the future.
The greater selectivity of the market is observed today in the fact that the correlation between equity securities has fallen to its lowest point in 20 years. This is a symptom that the prospects of individual companies influence theprogress of theirs stock market price. Weaker companies suffer from the rising cost of capital and debt and the likelihood of them being acquired at leverage decreases. Stronger companies, on the other hand, benefit from their lower debt and have less competition from zombie companies. The combined effect is that managers who are down on the former and up on the latter earn more and once again produce a lot of "Alpha", i.e. return explained by the selection of individual securities.
Also, because of how they are technically built wallets, HFs always have excess liquidity. For example, a 120% upside and 60% downside portfolio of stocks has a net market exposure of 60% (120 – 60) and will have 40% of the portfolio in cash (60 short – 20 leverage) on which now he earns 5%, i.e. 2% on net worth per year. In the past, the return on excess liquidity more than compensated for management fees, but in the decade with zero rates, HFs were unable to take advantage of the return on excess liquidity.
The crucial role of macro strategies in periods of high volatility
Between 2009 and 2019, the return on funds dedicated to Macro strategies was practically nil, despite the very strong performance of the stock market, leading to investor disaffection for this investment strategy. But recently high rates, the pandemic and geopolitical instability have given macroeconomic variables back the volatility that zero rates had suppressed and Macro managers are benefiting from this again.
Finally, the stock market has been dominated over the last twenty years by the migration of investors towards passive and indexed management. This trend has meant that passive funds in the USA have now surpassed actively managed ones in size. If we also add to the funds the very large institutional managers (such as sovereign funds), whose size prevents them from differentiating themselves from the indices, it is estimated that now more than 70% of the stock market is managed passively compared to 15-20% a quarter of a century ago. Only passive managers, thanks to commissions, and larger capitalization stocks have benefited from this enormous transition. But the phenomenon will mathematically not be able to have, in the next 20 years, the impact it has had in the past. And it is good that this is so because theindexing it is a phenomenon that has disconcerting and in the long run unsustainable aspects.
First of all, those who index give up carrying out their duty to select securities, a job that justifies the very existence of the market. And it parasitically takes advantage of the work of the remaining 30% of active management. Secondly, indexation has fostered unprecedented concentration. The top 10 stocks of the S&P500 constitute 1/3 of the value of the index, 10 years ago they were only 17%, half. But the function of the stock market cannot be to lower the cost of capital for a handful of oligopolists. A healthy market economy needs competition and when we observe that the top 10 companies in the S&P500 have on average net margins of 30%, i.e. double the average of the other 490 companies, we understand that the situation is probably unsustainable.
The challenge of indexing in the modern stock market
In conclusion, thanks to the normalization of monetary policies, theinvestment in HF is giving i again results hope. However, we do not know how high interest rates will remain. Demographics, lower productivity growth from less competition and more government intervention, productivity gains from disruptive new technologies, such as Artificial Intelligence, and more uncertain future inflation are all factors pulling in opposite directions.
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Antonio Foglia is vice president of the Board of Directors and shareholder of Banca Ceresio. Until 2010 he held the role of Managing Director and President of the Management Committee at Banca Ceresio. He is currently a member of the board of Belgrave Capital Management, Ceresio SIM and Global Selection SGR. He holds several additional positions on the management committees of private companies, universities, funds and foundations, including the Central European University and the Bruno Leoni Institute. He was a member of the Scientific Committee of Confindustria.
He is an occasional commentator on financial topics for the Corriere della Sera, Sun 24 Hours and the Financial Times.
Graduated in Political Economy from Bocconi University in Milan, he was born in 1960 and has Italian and Swiss citizenship.