investing in total return hedge funds

The global economy is about to enter a new phase of the interest rate cycle. Aggressive rate rises are behind us and most major central banks are setting out plans for looser monetary policy. 

As the outlook for interest rates becomes clearer, there is greater dispersion in the returns of individual asset classes. This, in turn, increases the number of relative value opportunities that investors can capitalise on.

In addition, while rates are set to decline, they are still likely to remain elevated – certainly compared with the era of zero to negative levels that followed the global financial crisis (GFC). This will lead to greater differentiation between companies and, therefore, more investment opportunities for fundamental stock pickers. In fact, historically, periods with high interest rates (above 4 per cent), have been characterised by strong returns and alpha generation by hedge funds.¹

With rates having peaked, companies will be more comfortable executing their longer-term strategy, leading to a gradual pick-up in public listings and mergers and acquisition (both of which have fallen sharply in recent years). Indeed, global M&A activity is forecast to increase by 50 per cent this year.² This broadens the hunting field for hedge funds which can leverage such events to maximise returns.

For all these reasons, we believe that the prospects for alpha generation for fundamental investors are improving as markets become more sensitive to stock-specific factors rather than macro-economic shifts such as the path of interest rates.

Investing globally with no benchmark constraints allows investors to take advantage of the different stages of the business cycle across the globe through a mixture of long and short positions.

Today, for example, growth in Europe is subdued, and stock dispersion is high (underscored by the divergences of the recent earnings seasons). Such an environment tends to reward stock picking.

Asia is another region that offers a rich hunting ground for stock pickers.

For instance corporate governance reforms in Japan (including new rules on price/book ratios) are incentivising cash rich and unlevered companies to start or increase their dividend and buyback programmes. Shareholders are successfully lobbying companies to focus more on measures that can boost profitability, and we think that Japan is also uniquely placed to benefit from a boom of strategic activity via M&A, spin-offs, manager buyouts or joint ventures. Corporate reforms are incentivising companies to dispose of non-core subsidiaries, adding to an already favourable environment created by tax incentives, low interest rates and ample availability of private equity capital.

We also expect to see continued high levels of corporate activity in South East Asia and Australia. The former is benefiting from strong economic growth, capital flight away from China and an improving regulatory environment. The latter, meanwhile, is capitalising on its powerful position in the global commodity industry which is vital to the energy transition.

China is a market that investors have found challenging over the past three years, given deflationary pressures and property sector weakness. Yet, China still offers many bottom-up opportunities driven by changes in, for example, consumption habits and technology, and how well companies are adapting to these. We thus favour consumer companies that respond to more discerning and pragmatic consumers and have a tailwind from overseas growth, while we are cautious on industrial companies facing overcapacity and price pressures. We also remain positive on the semi and tech hardware sector in the region given the strong AI capex cycle in the coming years. Recently, several companies have moved to bolster shareholder returns by augmenting dividend payouts or implementing share buybacks. Following positive share price reactions, an increasing number of other businesses are now considering similar strategies.

Overall, we believe that changing market conditions mean that investors require a more agile approach to portfolio construction, and that the strategic case for hedge funds is as strong as it has ever been. As part of a diversified portfolio of stocks and bonds, hedge funds have the potential to improve the risk-adjusted returns over the economic cycle. Not only do hedge funds represent an increasingly attractive alternative to money market funds, whose popularity will gradually diminish as central banks cut rates, but they are also able to offer a degree of capital protection in the event of market volatility.