Hedge Fund Investing Outlook 2024

June 6,2024

Business And Management

Hedge Funds With a Focus on Credit: A Surge in Demand 

Investment companies are showing significant interest in hedge funds specializing in credit investments. This marks the second consecutive year of heightened demand for these funds. The trend, noted in Goldman Sachs Prime Services' Hedge Funds Insights and Analytics team's 2024 Hedge Fund Industry Outlook, comes after a strong performance for both bonds and equities in the previous year. 

According to a global survey, capital allocators reported an average return of 6.4% on their hedge fund investments between January and November of 2023. This represents a notable increase from the 0.9% loss experienced during the same period in 2022. The report draws on responses from two key groups: 358 allocator firms worldwide with collective control over $1 trillion of hedge fund assets, and 302 hedge fund managers, clients of Goldman Sachs' Prime Services, who manage a combined total of over $1 trillion. 

The Strategies in High Demand 

"Credit is undoubtedly the strategy in the spotlight right now," remarks Freddie Parker, co-head of Prime Insights and Analytics in Global Banking & Markets, during a recent episode of Goldman Sachs' podcast, The Markets. 

Investor sentiment leans heavily towards hedge funds utilizing a credit strategy. A significant 44% plan to increase their exposure this year, whereas only 3% seek to reduce it. The report highlights a decline in interest for approaches like discretionary macro (assessing global markets from a high-level lens) and multi-strategy funds. 

Distressed credit and long-short credit strategies (which involve betting on bond price movements in both directions, often alongside hedging) remain the most popular sub-strategies within the credit hedge fund sphere. 

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How Interest Rates Shape Hedge Fund Performance 

"Broadly speaking, a high-interest-rate environment tends to favor hedge fund strategies over time," notes Parker. Historically, hedge funds exhibit improved returns when interest rates rise. This is partially due to the lower correlations they share with stocks and bonds, alongside a wider spectrum of potential investment outcomes. These factors combine to offer fund managers ample opportunities to outperform the average. 

Shifts in Sectoral Interest 

After a marked downturn in demand for hedge funds focused on the technology, media, and telecommunications (TMT) sector in the previous year, interest has now experienced a resurgence. TMT is now the most sought-after sector once again. Nevertheless, the report suggests this might reflect allocators rotating their TMT manager selections rather than a net increase in exposure to the strategy. 

Demand for energy and utilities funds continues to be relatively strong, whereas healthcare and biotech are experiencing a decline in popularity. Currently, only 14% of allocators anticipate increasing their focus on healthcare-focused managers. This represents a noticeable shift from 2020, when healthcare was a top-demanded hedge fund strategy. 

Changing Geographical Preferences 

Asia continues to experience a cooling of allocator interest. Having peaked in 2021 when nearly half of surveyed allocators expressed plans to increase Asian exposure, the region now finds itself the least sought-after, trailing behind both Europe and North America. Interestingly, within Asia, there's a slight uptick in interest for Japanese and pan-Asia strategies. This comes at the cost of Chinese strategies, which continue a downward trend. The report indicates that China comprised a mere 9% of allocator interest in strategies for 2024, a substantial decline from approximately 30% in 2020. 

For the first time in several years, investor appetite for Europe has surpassed that of the other two major regions. A significant 17% of allocators express intentions to increase their European allocation. However, it's important to note that the absolute level of demand for Europe has, in fact, decreased between 2023 and 2024, falling from the 20% mark seen in the previous year. 

Who's Investing in Hedge Funds? 

The survey also reveals a shift in the types of investors committing to hedge funds. Pensions and insurance companies, previously bullish on the asset class, are demonstrating a pullback. The report indicates that only 17% plan to increase exposure in 2024, a stark contrast to the two-thirds figure of 2023. 

"Rising interest rates are a key factor behind this change. Many corporate pensions are nearing fully-funded status, prompting them to adopt a more risk-averse stance and move towards liability matching. Simultaneously, fixed income investments are becoming more viable," the report states. Conversely, as pensions and insurers reduce their exposure, endowments and foundations are ramping theirs up, taking allocations to their highest level in five years. 

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Hedge Fund Performance Relative to Traditional Portfolios 

In 2023, hedge funds exhibited their widest margin of underperformance against traditional 60/40 portfolios (60% allocated to the S&P 500 Index, 40% to 10-year US Treasury bonds) since the year 2000. This can be attributed in part to hedge funds entering the year with a more defensive positioning, making it difficult to keep pace in the subsequent market rally. 

Despite this, the report highlights continued investor commitment to hedge funds and optimism regarding longer-term performance. Demand, from an absolute standpoint, remains strong. In fact, only private credit and long-only fixed income strategies exceed hedge funds in terms of allocator plans. 

"Sentiment around hedge funds is generally quite positive," observes Parker. "The challenge lies in a current shortage of liquidity. Investors are eager to put more into hedge funds, but they often don't have ready cash within their portfolios to deploy." 

Why the Interest in Credit? 

Several factors contribute to heightened demand for hedge funds specializing in credit. Firstly, traditional bonds, especially corporate bonds, experienced a difficult year in 2022 amidst rising interest rates. Consequently, numerous investors are searching for alternative ways to profit from credit markets, leading them to hedge funds with expertise in this domain. 

Furthermore, credit-focused hedge funds frequently hold the ability to execute more complex and nuanced strategies compared to traditional bond funds. This includes shorting bonds (profiting when prices fall), utilizing derivatives, and investing across various areas of the credit spectrum – from high-quality investment-grade to lower-rated distressed debt. These strategies can potentially generate returns that are uncorrelated with broader markets. 

What to Consider when Investing in Credit Hedge Funds 

Investing in credit hedge funds does come with a set of considerations. Notably, credit markets are less liquid than stock markets. This means it can be more difficult to sell positions quickly, particularly during periods of market turbulence. Additionally, credit markets can be complex and opaque, making it crucial for investors to conduct thorough due diligence on a fund's strategy and management team before committing capital. 

Hedge funds specializing in distressed credit carry additional risks. These funds buy debt of companies experiencing financial distress, betting that the companies can successfully restructure and return profits to investors. However, this is a highly speculative area, and there's always the possibility that a company might ultimately default, resulting in losses for the fund. 

ESG Considerations Grow in Importance 

Environmental, social, and governance (ESG) factors are playing an increasingly prominent role in investor decisions. According to the report, around 73% of allocators currently incorporate ESG factors into their hedge fund investment process. This figure is likely to increase further over the coming years. 

Many hedge funds now offer ESG-focused strategies, particularly in credit markets. These funds might specialize in sustainable bonds, debt issued by companies with strong ESG credentials, or impact investments that aim to generate both financial and social or environmental returns. 

Hedge Funds: A Long-Term Perspective 

Despite the underperformance seen in 2023, hedge funds retain their appeal as a diversifier within a broader investment portfolio. Their returns often demonstrate low correlation to traditional assets such as stocks and bonds, providing some potential to protect against market volatility. 

Over longer time horizons, hedge funds have historically outperformed standard market indexes. For savvy investors seeking a blend of downside protection and outperformance potential, hedge funds remain a compelling option. However, as with any investment, a thorough understanding of the strategy, risks involved, and the reputation of the fund manager is paramount before allocating capital. 

Navigating the Hedge Fund Landscape 

Choosing the right hedge fund strategy and manager is essential to investment success. Several factors should be carefully considered during the selection process. Firstly, it's vital to align the fund's investment strategy with your personal risk tolerance and objectives. Do you seek aggressive returns with higher risk, or are moderate returns with lower risk a better fit? Some hedge fund strategies are inherently more volatile than others. Consequently, gaining a solid grasp of the fund's strategy and risk profile is crucial. 

Additionally, analyzing historical performance is important, but one must remember that past performance cannot guarantee future results. Pay close attention to the fund's long-term track record, including performance during different market conditions. Next, hedge funds generally charge two types of fees: a management fee (typically 1-2% of assets under management) and a performance fee (often 20% of profits). These can significantly affect your overall returns, so carefully scrutinizing the fee structure is a must. 

Furthermore, the background and track record of the fund's managers are critical. Look for managers who possess considerable experience in the relevant strategy and a demonstrated ability to generate consistent returns across different markets. Finally, it's essential to understand the terms regarding liquidity (how easily you can sell your investment) and any restrictions on withdrawing your capital. Some hedge funds utilize 'lock-up' periods, during which investors cannot redeem their investments 

Due Diligence: Essential Before Committing 

Don't hesitate to ask in-depth questions about the fund's strategy, risk management procedures, and investment process. Additionally, request copies of the fund's marketing materials, offering documents, and any independent audits that have been conducted. Reputable hedge funds will typically be quite transparent about their operations. Therefore, any reluctance to provide information could be seen as a potential red flag. 

Role of Professional Advisors 

For investors less familiar with the hedge fund world, seeking the advice of a qualified financial advisor can be invaluable. Advisors can assist in identifying suitable hedge fund strategies, conducting due diligence, and managing the overall allocation with your investment portfolio. 

A Note on Regulation 

Hedge funds are generally less regulated than conventional mutual funds. This provides greater flexibility for fund managers but also carries a degree of risk for investors. As such, conducting thorough due diligence on the manager and strategy is crucial before making a decision. 

The Outlook for Credit Hedge Funds in 2024 

With interest rates anticipated to remain elevated in 2024, conditions should favour credit-focused hedge funds. This environment potentially provides opportunities for skilled managers to capitalize on market inefficiencies and generate attractive returns. Nevertheless, investors should always bear in mind the associated risks and conduct the necessary research before committing capital. 

Beyond Traditional Hedge Funds 

While traditional hedge funds often capture the spotlight, a variety of alternative investment strategies can also serve as diversifiers within broader portfolios. Let's briefly explore some notable options: 

  • Private Equity: Private equity funds invest in privately-held companies, often with the goal of taking them public or selling them for a profit at a later stage. Private equity can potentially offer high returns but comes with significant risks, including illiquidity and a lack of transparency. 
  • Venture Capital: Venture capital funds focus on investing in early-stage companies with high growth potential. These investments are extremely risky, but the potential for substantial returns can be enticing for some investors. 
  • Real Estate: Real estate investment trusts (REITs) and private real estate funds offer exposure to the property market. These investments can provide a source of income and some potential for capital appreciation. 
  • Commodities: Investing in commodities, such as oil, gold, or agricultural products, can act as a hedge against inflation. However, commodity prices can be notoriously volatile. 
  • Managed Futures: Managed futures funds use quantitative models to trade futures contracts across a diverse range of markets. They aim to profit from trends, regardless of the direction of the markets. 

Cautious Optimism: The Overall Outlook 

The overall environment for hedge funds in 2024 appears cautiously optimistic. With interest rates expected to remain elevated and markets potentially volatile, hedge funds may prove to be a valuable tool for investors seeking diversification and uncorrelated returns. However, remembering that hedge funds are not without their risks is paramount. 

Furthermore, not all hedge fund strategies will perform equally well in all market environments. Therefore, it's essential to select strategies aligning with your personal investment objectives and risk profile. 

As investors continue to seek strategies that can navigate challenging market conditions, hedge funds, especially those focusing on credit, are likely to remain in demand. With thorough research, careful selection, and the help of qualified professionals, hedge funds can potentially play a valuable role in well-constructed portfolios. 

Important Note: Hedge funds are complex and sophisticated investments. They may not be suitable for all investors. Consulting with a qualified financial advisor before investing is strongly recommended. 

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