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.
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.
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:
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:
Other considerations include:
[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:
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.
©All Rights Reserved. April, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Seasoned financial services executive with global leadership experience. Joe Burns is Head of Hedge Fund Solutions at iCapital Network, Inc. He has a dedicated focus on developing client solutions via alternative strategies, as well as diverse experience in product origination, multi-asset research, portfolio construction, risk management, business operations and consultative engagement with U.S. and international…
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