Hedge Funds ‘Can Survive a Fed Rate Shock’

Lyxor argues funds could reverse recent poor performance by riding out market volatility in the coming months.

A faster-than-expected hike in the Federal Reserve’s base interest rate could benefit hedge fund investors in the short term, according to Lyxor Asset Management.

Hedge funds have performed poorly in the years since the peak of the financial crisis in 2008 and 2009. The Lyxor report—co-authored by Jean-Marc Stenger, CIO of alternative investments, Jeanne Asseraf-Bitton, global head of research, and senior strategists Philippe Ferreira and Jean-Baptiste Berthon—said this was largely down to extreme monetary policy compressing yields and dampening equity market volatility.

Based on the historical correlations between the performance of US equity and bond markets and the performance of hedge funds, Lyxor projected three scenarios for hedge funds: normalization of policy rates as currently expected by the market, a faster-than-expected set of rate hikes from the Federal Reserve, and “secular stagnation”.

In the second scenario, increased volatility in equity markets would lead to greater opportunities for many hedge fund strategies, the report’s authors said.

“The third scenario—secular stagnation—would be the worst,” they said, as dispersion between valuations would be low as would volatility.

“Overall, hedge fund excess returns would be above 5% per year,” the authors predicted. “We believe that our 5% estimate is a minimum and there is upside potential from here.”

Lyxor’s research into performance and correlations between 1990 and 2015 found that hedge funds generated an average 4.5% of excess return between 1990 and 2009. Since 2009, this figure collapsed to just 1.2%, the researchers said.

“The fall in bond yields in the wake of the Fed’s quantitative easing programme has negatively impacted hedge funds,” the authors said. “Additionally, the equity beta has fallen while stocks rallied and alpha generation has shrunk as a result of the low volatility/low dispersion environment. However, alpha generation has started to rise since mid-2014 and the environment is now improving, with valuations stretched across the board, the economic cycle maturing, and the Fed beginning to normalise monetary policy.”

Related: The Amazingly Consistent Hedge Fund Universe (Except for Fees and Performance) & When (Not) to Buy a Hedge Fund