For Hedge Funds, Rising Rates Mean Opportunity

November 09, 2023
5 min read

Global interest rates have soared. So have volatility and dispersion across markets. We think it may be time to consider adding exposure to hedge funds and alternative strategies that don’t depend on market beta to generate returns.

Investors this year have come to terms with a stark reality: the days of rock-bottom interest rates are over. Borrowing costs in major economies have climbed since early 2022 at their fastest clip in 40 years. And with inflation elevated, we think they’re going to stay high for a while

This new normal has depressed corporate earnings expectations, making markets more volatile and prompting many investors to adjust their asset allocations. We think there are many public market solutions they may want to consider. These might include a more selective approach to equities or a tilt toward bonds to capitalize on the increased income and return potential that come with higher yields.  

But a higher-for-longer rate environment also highlights the importance of alternative strategies driven less by market direction and more by volatility. We see three approaches with potential to boost returns in current conditions. Some rely on fundamental processes to generate return, others quantitative ones. All have the potential to complement traditional equity exposure and enhance diversification through returns that exhibit low long-term correlation to the broader market.

The Long and Short of Higher Interest Rates

Long/short hedge funds, which seek to profit by buying—or going “long”—equities expected to rise and selling “short” those expected to decline, struggled in the years after the global financial crisis. At their core, these strategies are about picking the right stocks at the right time, and that was difficult to do when record-low interest rates were causing nearly all stocks to rise.

The market landscape is very different today. Volatility has risen sharply with interest rates over the last 18 months, causing increased dispersion of equity returns. That’s good news for stock pickers. Recent history suggests that extended periods of high rates create more opportunity for long/short strategies. 

When we looked at three periods in recent decades in which interest rates hovered between 5% and 6% for at least six months, we found that the average three-month implied volatility of S&P 500 returns was higher than the full period average from 1979 to 2023 and average three-month stock correlations were lower (Display). With interest rates likely to remain high in 2024 and possibly beyond, we expect these market conditions to persist.

More Volatility, Less Correlation
More Volatility, Less Correlation

Past performance does not guarantee future results.
*The average of monthly data for the three time periods
†The monthly average from December 1979 to March 2023
As of April 30, 2023
Source: Bloomberg, Goldman Sachs and RiskMetrics

That suggests plenty of long/short opportunities for investors. Even in a high-rate environment, cash-rich companies with robust free cash flow may be able to act in ways that benefit shareholders—think acquisitions or strategic investments—while continuing to service debt. Those struggling to generate cash will have fewer options. And those with debt coming due will have to refinance at higher rates, raising their cost of capital and putting additional strains on their operations.

Because long/short strategies are one of the most commonly used by hedge funds, manager selection is important. Multi-portfolio manager strategies, in our view, may provide valuable return diversification and risk management that could help reduce downside risk. Meanwhile, significant unencumbered cash balances today can contribute to returns thanks to elevated cash rates. 

Merger-Arbitrage: Higher Rates, Higher Spreads

Merger arbitrage strategies seek to generate returns by purchasing the stock of a company targeted for takeover and collecting the difference—or spread—between its current price and its price when the acquisition closes. In a rising interest-rate environment, investors can demand wider arbitrage spreads, which stand to increase overall return potential. 

Of course, rising rates can slow the pace of merger activity, as they have this year. But that may be an advantage for companies with strong free cash flow that face less competition in today’s high-rate environment. As long as an acquisition doesn’t require taking on a lot of new debt at higher rates, it might be a good way for management to increase market share and operating revenue. 

The potential returns from merger arbitrage have exhibited low correlation to long-term market direction. Most deals eventually close—and the spread acts as a premium for accepting the risk that the deal falls through. Put simply, it doesn’t matter much what the broader equity market is doing in the background. As long as the deal is completed, the target will get paid what was offered and the investor will collect the risk premium.

Again, manager selection is important, particularly with sharper US and UK regulatory scrutiny of deals. Some managers employ a discretionary approach, investing only in deals they determine have the best chance of closing. Others invest more broadly but size positions differently based on risk, an approach that may help reduce return volatility if one or more deals fall through. Investors should vet managers’ track records, experience and due diligence processes carefully before committing.

Systematic Macro: An All-Weather Approach

High interest rates put pressure on economies—both developed and emerging—across the globe. This can create opportunities that systematic macro strategies—another large and well-established hedge fund category—are well-equipped to exploit.

Systematic macro is a heterogeneous category that makes directional and relative value trades across asset classes and geographies. Both are helpful in providing diversification when markets are volatile.

In practice, managers attempt to tap into distinct return streams that are uncorrelated to broad equity and bond markets. These signals are numerous and vary widely from manager to manager. They might include well-known categories like “carry,” and “trend” as well as proprietary categories specific to individual managers.

Managers use derivatives to take long and short positions in a wide range of asset classes, including equity indices, bond markets, currencies, commodities and equity sectors. 

In higher-rate environments, different signals within a systematic macro portfolio will react in different ways. For example, “carry” benefits directly from interest rate dispersion, while “value” might suffer from it. But diversification of risk across signal categories typically helps keep overall portfolio performance uncorrelated to specific market regimes or economic environments.

Because these strategies rely on derivatives rather than physical assets, they are highly cash efficient. Like equity long/short strategies, they typically have excess cash on hand, which at today’s high interest rates can help to increase total return.

We believe a robust and durable portfolio is a diversified one. Hedge fund strategies have the potential to complement more traditional equity and bond allocations in all types of weather, but we think they can be especially valuable when market conditions are changing.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

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