How to Evaluate Future Hedge Fund Returns Using Market Environment and Strategy Analysis

What Drives Future Hedge Fund Returns?

With a surge in hedge fund performance in the beginning of 2021, investors are right to wonder what is driving this increase in returns and renewed investor interest. With thousands of hedge funds spread across multiple strategies and differing levels of performance, it is critically important to understand drivers of performance and the corresponding outlook for future hedge fund returns.

Evaluating Market Environment for Future Hedge Fund Returns

The market environment is more significant than market direction in developing an expectation of future hedge fund returns. At a basic level, the majority of hedge fund strategies are “short correlation and long dispersion.” This means that a market with declining correlations (i.e., securities are not all moving in the same direction) and rising dispersion (i.e., wider gaps between top and bottom performing securities) within and across asset classes is the ideal investment climate for most hedged strategies.

While previous years had been dominated by Central Bank policies and various forms of quantitative easing, correlations became extremely high. At the same time, the outcome dispersion for stocks, bonds and other types of securities was extraordinarily low. This meant that within classes, assets were generally all moving in the same direction. And, there was little variation between individual performance.

However, most recently, we are seeing lower correlations, higher volatility and rising stock dispersion, which makes active strategies more appealing. According to a 2021 Credit Suisse survey of more than 200 institutional investors representing $800 billion in hedge funds, demand is on the rise due to lower cross-asset correlations. This differentiated hedge fund performance serves an increasingly significant role in diversifying the traditional 60/40 portfolio model.

Understanding Specific Hedge Fund Strategies

In addition to assessing market conditions, investors should understand the primary sources of return in different hedge fund strategies and their underlying investments. These return drivers can be analyzed qualitatively, statistically and operationally.

From a qualitative perspective, investors should understand the specific investments held by a hedge fund manager. They should look at the construction of the overall portfolio, including:

• The dollar amount and number of shares of certain holdings
• Which regions and sectors are favored
• The stylistic composition of the fund
• The liquidity, concentration, leverage and complexity of the overall investment strategy

Statistically, beyond an assessment of historical returns, investors should feel comfortable with the risk-adjusted performance profile of a fund in relation to their investment goals. This could include an analysis of:

• Performance of the fund based on historical volatility in markets
• The potential for declines in fund performance if market conditions change
• The drawdown potential, or the possibility of losses, down from a performance peak

Other considerations include:

• The correlations with other holdings within an investor’s portfolio (uncorrelated assets create diversification in a portfolio)
• Market beta (a fund’s dependency on broader markets as a core driver of performance)
• The contribution to returns from alpha, or manager-specific performance, above and beyond a relevant benchmark

[Editor’s Note: To learn more about alpha and beta, get our webinar Alpha, Beta & Other Key Concepts and check out a short clip from the webinar below.]

Lastly, investors should also assess the operational capabilities of each firm regarding:

• Internal policies and procedures
• Pricing and valuation methodologies
• Connection with top-tier service providers
• Commitment to institutional best practices in managing not only an investment fund, but an overall business

Too often, investors rely upon historical performance and extrapolate future hedge fund returns to make an investment decision. Drilling into the sources of return, the statistical robustness of the performance and the strength of each firm’s operational processes is just as important. In fact, it is likely more predictive in assessing the future impact of each investment within a diversified portfolio.

---

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: What is a “Private Fund?”; PE, VC, and Hedge Funds De-Mystified; and Due Diligence Before Investing. This is an updated version of an article originally published on June 29, 2018.]

©All Rights Reserved. April, 2021.  DailyDAC^TM, LLC d/b/a/ Financial Poise^TM