Research and Insights
The ‘new normal’ creates new opportunities and threats for the global hedge fund industry
April 14, 2021
A year since the onset of the COVID-19 pandemic, the new world we now live in has been dubbed the “new normal”. Fundamental changes have taken place to the way we live, work and invest, and many of them may be permanent.
This new paradigm creates both opportunities and threats for the global hedge fund industry, a subject of interest to us at Prelude Capital, given that we currently have allocations with more than 150 hedge fund managers internationally, over $7bn in total.
Consider what has happened in the last year. Governments around the world have reacted in different ways to the COVID-19 pandemic, but what is almost universal is that severe constraints have been placed on normal life. Lockdowns and other restrictions have sought to reduce social contact by closing offices, schools, shops, cafes and restaurants, while travel has been severely curtailed.
This has had major negative impacts on sectors like aviation, tourism, hospitality and consumer goods. In order to prevent mass unemployment, governments have created support programs and paid for them by issuing epic quantities of new debt. Meanwhile central banks have stepped into markets, dramatically increasing the size of their balance sheets. Monetary and fiscal policy has been aggressive and loose. There has been a recovery but it has been “K” shaped, with much lost ground still not made up.
All this has created winners and losers. Certain sectors have flourished in the crisis, such as technology and biotech, even as others have been badly hit, meaning that there is now considerably increased dispersion in share performance. And volatility is now back. For many years after the global financial crisis, it was often said that central bank intervention had killed volatility in markets. But now it is back with a vengeance, as markets have taken a roller-coaster ride from peak to trough and back again.
All of this ought to be good for hedge funds. Investors often look to hedge funds in difficult periods to protect their assets because of their ability to provide downside protection and to actively manage risk. Increased dispersion should mean better opportunities for stock-pickers, while more volatility should mean more trading opportunities for the industry. Historically aggressive fiscal and monetary action in response to COVID-19 has created clear trends such as rates staying low for long and credit spreads remaining tight, which can benefit actively-managed strategies.
And indeed, hedge funds globally are confident entering 2021. That’s the conclusion drawn by the industry trade body, the Alternative Investment Management Association (AIMA), in its new Hedge Fund Confidence Index (HFCI).
The index measures the level of confidence that hedge funds have in the economic prospects of their business over the next 12 months. Respondents were asked to choose from a range of -50 to +50, with +50 indicating the highest level of economic confidence in the firm. Respondents were also asked to take into account the following factors: their firm’s ability to raise capital, their firm’s ability to generate revenue and manage costs, and the overall performance of their fund(s).
With over 200 hedge fund firms responding, the average measure of confidence was +14. This is strikingly positive given how challenging 2020 was for the industry and may at first appear counterintuitive.
After all, the traditional criticism of the industry is that it has lagged behind leading U.S. equities indices in terms of performance since the spring of 2009, when the great central-bank fuelled bull-run in equity market valuations began internationally following the shocks of the global financial crisis.
This trend continued in 2020, as the S&P 500 ended a tumultuous year at a new high of 3,756.07 – a gain of 16.3% in 2020. Meanwhile, Hedge Fund Research’s HFRI 500 Index, a fund-weighted composite index often used to gauge overall industry performance, was up only 5.6% for the year in December.
Of course, caveats apply to any aggregate measure of industry performance. Many funds do not report to indexes for either good reasons (they are closed to new investors) or bad ones (they are closing down), so the indexes can only capture a partial picture. The industry features a multitude of different strategies, many of which are either uncorrelated to each other or indeed negatively correlated to each other, meaning that when seen in aggregate performance by some strategies can cancel each other out.
Because of this, it is worth stressing that many investors in hedge funds have received considerably better performance than the industry aggregate number, and some will have indeed received better performance with lower volatility than their allocations to passive investments such as exchange traded funds.
EY’s 2020 Global Alternative Fund Survey looked at this and concluded that investors were generally pleased with how managers operated their firms during a crisis. A clear majority of investors were satisfied with their hedge fund allocations in 2020, with 58% concluding that these met or exceeded performance expectations.
The consequence of this can be seen in other metrics. The third quarter of 2020 saw net inflows into the industry of $13 billion, according to Hedge Fund Research, which was the first time since the first quarter of 2018 that there had been positive inflows into the industry.
HFR also recorded the highest level of new hedge fund launches (an estimated 151) in five quarters in the third quarter of 2020, the first time since the second quarter of 2018 that new launches outnumbered liquidations.
But the “new normal” brings significant threats to the hedge fund industry, too. Violent market movements result in greater performance dispersion, which means more losers as well as more winners. This can be seen in HFR performance data for January. As a whole, the index was up 0.92%, but the top decile of the HFRI 500 index was up 11.6% while the bottom decile fell 7.8%.
And there is likely to be more of this to come. The continuation of aggressive and loose fiscal and monetary policy of the “new normal” may well ultimately lead to historic distortions in capital markets and thus historic volatility.
We are likely to see on-going macro-economic uncertainty and further market corrections as well as dramatic new areas of growth. In the hedge fund industry, as in the broader economy and financial markets, the return of volatility is a double-edged sword.