“Goldilocks” and the three drivers of hedge fund outperformance

The hedge fund industry is now mature enough that we can assess hedge fund performance across different market regimes. The 1990s and 2000s were strong decades for hedge funds, as they significantly outperformed a 60% equity/40% bond portfolio (Figure 1) as well as the broad equity market. The 2010s proved more challenging, with hedge funds — and macro funds in particular — generally delivering lackluster returns. The 2020s have started on a stronger note, especially for equity long/short funds (right side of Figure 1).

Will this improved performance continue? We believe the answer lies in the prevailing economic and market regime. Looking at a range of historical data, we find that “Goldilocks” periods of low stock dispersion and low macro volatility — while good for investors’ overall portfolios over the last decade — have been challenging for hedge fund returns. Low interest rates have also been a headwind to hedge fund returns (despite the often voiced argument that higher rates are problematic for hedge fund leverage). However, when markets have been volatile and interest rates higher, hedge fund returns have been strong. In other words, hedge funds have been a source of compelling returns when investors have needed it most.

Today, we believe we are at a turning point for economic conditions, and we think the nascent market backdrop is likely to benefit hedge funds and once again make them a potentially valuable addition to a multi-asset portfolio.

At the same time, the historical data shows the magnitude of hedge fund returns generally falling over the last three decades. In the 1990s, the hedge fund industry was in its infancy. Competition for talent and trade ideas was sparse, regulation was light, and many strategies that hedge funds use to generate returns were obscure. Today, the hedge fund industry, at about US$4.3 trillion, is more than 110 times larger than it was in 1990 and very much in the spotlight.¹ We think this makes manager selection critical to long-term success today in a way that it might not have been in the 1990s.

This paper reviews the historical data to show how patterns of hedge fund returns are linked to trends in the broader economy. Ultimately, we argue that the years ahead are likely to be fruitful for hedge funds, but that investors will still have to focus on choosing the right managers.

A couple of notes on our research. First, we focused on what are generally considered the industry’s four main strategy groups: equity long/short, relative value, macro, and event-driven funds. Second, we acknowledge that hedge fund industry data, like other historical fund data, is subject to certain biases, such as survivorship bias (indices may exclude funds that closed or stopped reporting) and self-selection bias (underperforming funds may opt out of the indices), but we believe our research conclusions would still be valid even if we were to control for these biases.

Three drivers of hedge fund returns: Dispersion, volatility, and interest rates

We believe several market factors played a crucial role in the success of hedge funds during the 1990s and 2000s:

• Security dispersion, a measure of the degree to which the returns of individual securities (e.g., stocks or bonds) deviate from one another, was high. This provided hedge funds, such as equity long/short funds, with a rich hunting ground for alpha through security selection.
• Macro volatility, which captures fluctuations in macroeconomic variables (e.g., currencies, interest rates, and inflation), was elevated. This created a dynamic environment that was ideal for hedge funds that seek to exploit top-down economic events.
• Interest rates were meaningfully higher than today. Higher rates tend to coincide with higher volatility and dispersion, which, as noted, may be favorable for hedge funds. Higher rates are also beneficial because hedge funds usually maintain substantial cash reserves to implement trades using derivatives and leverage. The active returns hedge funds generate from long and short positions — whether in equity or bond markets, individual securities, or futures — generally come on top of the returns that hedge funds earn on their cash balances. In addition, credit hedge funds typically own leveraged loans and high-yield bonds, which produce more income in higher-rate environments.

Figure 2 shows how security dispersion, macro volatility, and interest rates compared on average between the 1990s/2000s (blue dashed line) and the 2010s (orange dashed line). The difference is stark and likely explains the tame performance during the latter period.

Goodbye, Goldilocks

Today, however, we see evidence that the economic regime is returning to a pre-2010s environment that could be supportive for hedge funds broadly. In the Figure 2 charts, we already observe upticks of varying magnitude in security dispersion, macro volatility, and global interest rates.

What’s driving the shift? We believe we have moved from the relatively stable environment of the 2010s to an economic regime characterized by:

1. Structurally higher inflation driven by a tighter labor market, underinvestment in commodity production, higher fiscal spending (e.g., to combat climate change), and deglobalization (reflected in higher tariffs and other trade disincentives)²

2. A tricky monetary policy balancing act for central banks as they try to address higher inflation while also supporting economic growth, resulting in more economic uncertainty and policy variations across different regions

3. More active government involvement in the economy via regulation and industrial policy

All of this is likely to add up to higher levels of macro volatility and more dispersion in economic outcomes at the country level. This should feed through into more dispersion between the performance of individual securities. Macro volatility and stock dispersion often coincide, as shown in Figure 2.³ Interest rates, inflation, and growth fluctuations impact companies differently. For example, higher inflation may benefit energy companies as energy prices rise but hurt consumer goods companies facing higher raw material and labor costs. More generally, business cycle pressures generally drive wider dispersion between “winning” and “losing” securities, revealing flaws in corporate management teams, strategies, or balance sheets that were camouflaged when times were good.

Finally, structurally higher and more volatile inflation, combined with increased fiscal and industrial policy, should lead to higher interest rates. Figure 3 summarizes the impact of the new regime.

What the new regime could mean for hedge fund returns

Historically, periods of high security dispersion, high macro volatility, and high interest rates have coincided with strong hedge fund outperformance.

Security dispersion

The left chart in Figure 4 looks at how equity long/short funds fared in different environments for security dispersion. Specifically, we use the five-year rolling beta-adjusted outperformance of equity long/short funds relative to the global equity market. Equity long/short funds were able to generate strong outperformance during periods of above-average security dispersion (highlighted in light blue).

The right chart shows average annualized returns in periods of low/normal security dispersion and in periods of high security dispersion. It’s clear that long/short managers generated their outperformance in the latter.

Macro volatility

Figure 5 looks at how macro hedge funds performed in different economic environments. We compare the five-year rolling outperformance of macro funds versus a 60% equity/40% bond portfolio. We used the 60/40 portfolio rather than global equities because the former is more comparable to macro funds, which tend to take less risk than equity long/short funds and have a larger fixed income component. We did not beta adjust the returns given that macro funds tend not to carry a lot of equity beta.

The left chart shows that macro funds outperformed when macro volatility was above average (highlighted in light blue). The relationship is clear, though marginally less strong than in the security dispersion analysis above. The right chart shows that macro funds generated much stronger average annualized returns than the market in periods of high macro volatility and were more in line with the market in periods of low or normal macro volatility.

Interest rates

Figure 6 looks at how hedge funds performed in different interest-rate regimes. Specifically, we compare the 5-year rolling outperformance of hedge funds broadly (all four categories noted earlier) versus a 60/40 portfolio. (We used a 60/40 portfolio to represent the opportunity cost of investing in hedge funds.)

The left chart shows that higher interest rates have typically been associated with hedge fund outperformance, which, as highlighted earlier, we attribute to several factors, including the funds’ large cash reserves and the higher macro volatility and security dispersion associated with higher rates.

Is the average return experience helpful? The value of manager research

Careful observers of the charts above will note that — notwithstanding the relationships we highlight between volatility and hedge fund returns — there is also a general pattern of better hedge fund performance in the 1990s and early 2000s than in the years since. We think this reflects the evolution of the hedge fund industry.

Since the 1990s, the hedge fund industry has grown significantly — including the size and number of funds — and the regulatory landscape has impacted how funds operate. While the pros and cons of these changes can be debated, we think one thing is clear: The war for alpha between hedge fund managers is as intense as it has ever been.

We believe this is a reminder of the importance of manager selection for anyone allocating capital to hedge funds. Our data shows that manager selection is critical in periods when hedge fund returns are challenged. In the 2010s, for example, even as hedge funds on the whole were delivering the lackluster returns we saw in Figures 4 – 6, top quartile managers were still generating strong returns for their investors — as we show in Figure 7. Said another way, top-quartile managers may be able to outperform the market even when the economic and market dynamics are less supportive.

In the years ahead, a rising tide may lift all hedge fund returns, but we expect the strongest managers to make the greatest contribution to their clients’ portfolios — and, as noted earlier, this may come when investors are in greatest need of diversifying sources of returns.

Manager selection: Getting hedge fund exposure “just right”

Ultimately, even with a more supportive return backdrop, today’s large and diverse hedge fund universe makes the manager research capability critical — especially in the effort to identify and secure access to top-tier managers who may be in high demand and have limited capacity.

We think the manager selection process should include both qualitative and quantitative analysis and focus on what we refer to as the “three Rs”: 1) the role the manager’s strategy will play in the overall allocation, 2) the risks the manager takes, and 3) the residual alpha potential (i.e., manager skill). This framework draws on our factor-based analytical approach; we think factors can be valuable in helping to tease out a manager’s natural style biases and the market environments in which alpha generation may be most or least likely. Read more on manager research best practices here.

Given the complexities of manager selection and its impact on outcomes, as well as the challenge of gaining access to good managers, some allocators rely on multi-strategy hedge funds as a one-stop solution. The multi-strategy manager is then responsible for selecting the underlying allocations to different hedge fund categories. When our team creates and manages multi-strategy hedge fund portfolios for clients, we leverage the manager selection framework above, combined with a robust set of proprietary tools to help with risk management and ongoing oversight.

Next steps for the new regime

If our longer-term macro view is correct, then we may not see a repeat of the 2010s “Goldilocks” period any time soon. Investors could find the market backdrop more challenging in some respects, but hedge fund managers may find more ways to generate alpha and their clients should benefit.

To prepare for this potential shift, investors should review the size and composition of their hedge fund portfolios. Hedge fund exposure should be large enough to make a meaningful contribution to their objectives — and to be able to dampen total portfolio volatility in turbulent markets. Hedge fund portfolios should also be aligned with investors’ broader return and risk objectives; our research on the role of hedge funds in a portfolio can help identify the right blend of strategies. Finally, given the increased competition in the hedge fund world, investors should review their approach to manager selection and take advantage of the key principles we outline above.