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.
