Which Hedge Funds Will Do Best With Rates Rising?

Hedge funds are earning their keep lately. According to Hedge Fund Research, their worldwide index is up almost 2% this year, which is a lot better than stocks and bonds, both down more than 10%.

But surging inflation is a fact of life in the investing area these days. That is not good for investments in general, especially if the high inflation persists. So which types of hedge funds should do best in such an environment? Don Steinbrugge, CEO of consulting firm Agecroft Partners, has an answer: commodity trading advisors, higher turnover relative-value fixed income, and reinsurance.

As he sees it, “rising short-term rates can have a positive impact” on this trio of funds. “Short-term rates rising from close to 0% to potentially well over 3% should have a direct and meaningful positive impact on the expected returns for these strategies moving forward,” he says.

Commodities are soaring these days, and the HFR commodities index is ahead 11.6% this year. Sure, oil and many scarce raw materials have done well, but commodity trading advisors have a special power, Steinbrugge notes. “CTAs deploy only 10-20% of their capital,” he explains. The rest sits in short-term fixed-income instruments. Rising rates boost them.

Relative-value fixed-income funds are trading-centric, as they have replaced many of the fixed-income desks that Wall Street firms used to run before the 2008 financial crisis. Year to date, these are up 0.26%, HFR reports. Not stellar, but lots better than the red ink seen in legacy stocks and bonds.

The rapid volatility that has rocked the markets is good news for these vehicles. “Skilled managers generate most of their return through alpha and limit market beta by actively hedging both interest rate and credit spread risk,” Steinbrugge explains. “These strategies also have low correlation to the capital markets and can provide some tail risk protection during market selloffs.”

Reinsurance depends largely on catastrophes, such as hurricanes, which tend to cluster in the end of a calendar year. Over the past 12 months, which takes in the most recent peak-activity season, the industry is up 6%, per the FT reinsurance index. By Steinbrugge’s reckoning, hedge funds specializing in this area have seen yields as high as 4%. As with RV funds, reinsurance ones also need to have large reserves invested in short-term fixed income.