Hedge funds as a group underperformed over the past ten years, but, by definition, they shouldn’t be expected to outperform the indices in a bull market to the extent that they do hedge. And there are hedge funds and there are hedge funds – in other words, they are not all the same. Some are very aggressive – and some of those did outperform.
Today the headwinds faced by hedge funds are giving way to tailwinds in the new cycle. Over the past decade, lower and lower interest rates drove investors to embrace greater and greater risk by chasing yield and piling into a handful of growth stocks, the so-called FAANGs – Facebook, Apple, Amazon, Netflix, Alphabet (Google).
The consensus among the older generation of hedge fund managers is that this is a time for caution. In contrast, many of the younger managers seem to be more constructive…
Such conditions were not ideal for hedge funds, because, by definition, they are not long-only – they are long and short, and the short side was especially difficult. For that matter, the long side also was challenging for many, because stock picking generally, and value investing in particular, lagged relative to indices that were dominated by the FAANGs.
Markets have now entered an Age of Anxiety. I think we are going to see an extended period in which investor sentiment swings between extremes of optimism, anticipating a return to normality, and pessimism, worrying that the pandemic will have damaging economic, social, and political aftereffects that will persist longer than expected.
Investors should be diversifying their portfolios to deal with a coming era of heightened economic uncertainty and market volatility, but this does not mean that we are mired in a deep economic depression or extended bear market.
Quite the contrary. Investors with a long horizon should do well with equities. But – and this is an extremely important ‘but’ – in the intermediate term, it will be very difficult to generate meaningful returns in conventional asset classes.
Investors must make room in their portfolios for alternative investments because their ability to hedge can provide much-needed downside protection and diversification during volatile times for equities. Hedge funds have the potential to be an important alternative to fixed income particularly since government bond yields are at rock bottom and remain vulnerable to increasing inflation.
Interestingly, the consensus among the older generation of hedge fund managers is that this is a time for caution. In contrast, many of the younger managers seem to be more constructive, not so much about the market, but about specific investment ideas for which they have an enthusiastic conviction.
It is therefore critical to be highly selective about managers and to have a keen understanding of their ability to manage risk. Keep in mind the old saying about aviation: “there are bold pilots, there are old pilots, but there are no old bold pilots.”
Strategically, there are at least three specific areas of opportunity that stand out: First, long/short specialists with expertise in healthcare and biotech are well-positioned to benefit from secular trends as well as COVID-related opportunities in the sector.
Second, strong economic growth in Asia appears to be a durable secular trend, so regional specialists have the opportunity to take advantage of investment opportunities especially in China and India.
Third, ongoing volatility creates trading opportunities, so a well-diversified mix of macro and market neutral strategies has the potential to produce stable, high single-digit returns, which is especially attractive relative to the very low yields on Treasuries.
The implication is clear. You can be constructive on the long-term outlook, but it is imperative that you balance this with defensive diversification in the intermediate-term via hedge funds.
This could well be a new golden age for hedge funds.
Dixon Boardman is vice chairman of the Forbes Family Trust, and CEO and founder of Optima Asset Management