Some hedge funds are finally seeing market conditions to justify their existence

Some hedge funds are finally seeing market conditions to justify their existence

Hedge funds have to adapt to a radically different market environment this year. For some, life has become much more difficult. But for others, these are exactly the conditions they had been waiting for for a long time.

A new world of high inflation, sharply higher interest rates, and rapid quantitative tightening, unimaginable just a few years ago, have upended stock and bond markets over the past six months. Eurozone inflation this week hit another record high of 8.1 percent, adding pressure on the European Central Bank to speed up interest rate increases.

High-growth technology stocks in particular have been hit hard. While they can rise to massive valuations when interest rates are close to zero, higher rates mean their future earnings look relatively less attractive. Tiger Global and some of the other “Tiger cub” hedge funds that boomed during the bull market have felt the full force of this massive sell-off, in some cases losing significantly more than the broader market.

But for some managers who are focused on exploiting the price differentials between stocks, conditions are now in their favour. They were frustrated by “everything high” as investors often seemed unconcerned about whether they were buying a high-quality or low-quality company. However, removing the very low-cost financing that had long been available to companies began to separate the wheat from the chaff.

“Neutral market [equity] Low net worth should benefit from equity. . . The fundamentals now reflect,” said Kier Boley, chief investment officer of UBP’s Alternative Investment Solutions, referring to funds trying to make money off the weight of one stock against another, rather than betting mostly on higher prices.

London-based Sandbar Asset Management is a good example of how conditions are changing for such funds. A year ago, I wrote in this column that the $2.2 billion company, founded by former millennium trader Michael Cowley, was struggling with the seemingly inconsequential way the markets work.

For example, Sandbar said the relationship between improved expectations about a company’s earnings and the reaction in its stock price, which should intuitively be positive, has fallen “to levels not seen in the past decade.” In some sectors such as the airline industry, it has turned negative, which means that improving earnings expectations would actually push the stock price down. Sandbar finished the year down 7.5 percent.

A lot has changed since then. The fund is up 6.7 percent in the first four months of this year, compared to a 7.3 percent decline in equity hedge funds on average, according to data group HFR, and a 14.5 percent decline in the S&P 500 as of Wednesday. .

Significantly, so-called alpha — industry terms for the money the manager makes on his skill rather than just following overall market movements — has been positive for the fund in each of the past four months.

One of the main reasons, according to Sandbar, is the fact that markets have now entered the “last stages of the economic cycle.” In a letter to investors, she wrote, this marks a time when conditions were more supportive for funds like themselves. This was due to “Dispersal [between stocks] Increases dramatically” while returns from just following the market moderate or turn negative.

She added that the cancellation of positions by other investors at the end of last year and early this year as the market plunged created opportunities for profitable Sandbar in recent months.

While the outlook for these managers has improved significantly, there are still factors that can hinder their progress. Stocks have risen over the past two weeks on hopes that bad news from the economy will convince central banks to limit interest rate hikes. And as UBP’s Polly points out, even if a manager gets an analysis of the stock’s fundamentals right, a major investor can still be derailed.

However, this sifting of the industry, long anticipated but often delayed by years of central bank stimulus, is being welcomed by many.

For most of the past decade, hedge funds have struggled to justify why investors should pay their high fees when returns were often uninspiring compared to index-tracking funds – available at a fraction of the cost – or compared to the profits apparently offered by private equity funds.

In a world where returns on stocks and bonds are now less attractive, hedge funds that are not just trying to ride the markets but instead exploit market imbalances may have finally come to their stride.

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