Allocators are facing tough challenges
With core inflation slow to normalise, central banks are constrained in their ability to ease their policy at a time of elevated liquidity stress and deteriorating credit conditions. As a result, carry trade should remain volatile and confined to government bonds and Investment Grade.
Multiple opposing forces are making it challenging to sequence the path of the global economy, albeit increasingly tilted to the downside. With investors pricing rapid inflation normalisation, faster monetary easing and no recession, cyclical assets remain vulnerable.Portfolios’ risk management is also challenging amid unstable cross-asset relationships and with the threat of additional liquidity shocks. Structurally greater risks from geopolitics and politics are unusually impactful for fiscal policies, regulations, trade flows, corporate operations and thus for markets and allocations. Meanwhile, investors do not want to miss carry opportunities and are seeking to benefit from uneven regional stories and other decoupling segments. While keeping positive optionality, they are looking for protection in case of a hard landing.
We contend that hedge funds respond to most of these challenges for 3 main reasons.
3 reasons why hedge funds are a particularly good fit in this environment
1) Hedge funds provide good protection in an inflationary environment
Hedge funds are dynamically arbitraging inflation.
Surging inflation means more volatility, active central banks, valuation dislocations, i.e. more opportunities. It helps hedge funds remain resilient in inflationary episodes. They usually outperform traditional assets, thanks to uneven strategies’ sensitivity to inflation.
They then tend to perform even better when inflation normalises. Past the inflation peak, multiple convergence trades open up, highly profitable for hedge funds, as economies gradually return to their equilibrium and as investors’ focus shifts from inflation and rates to economic growth
As they are structurally long cash, hedge funds also tend to benefit from higher rates.
2) We believe hedge funds’ capacity to generate alpha has increased
Above-par volatility regime likely to persist, an optimal equilibrium for hedge funds
Volatility is a decisive factor in setting an allocation’s risk level and targets with major implications for alpha generation.
Secular trends suggest the volatility regime will remain above par, due to structurally higher geopolitical and social risks, stalling globalisation and a more multipolar world, and shorter economic cycles. The challenges and cost of climate change, as well as several disruptions that will change the nature and structure of work, would also support volatility.
Our volatility regime models, which track both short-term and long-term volatility drivers, suggests the same.
This regime is optimal for hedge funds, providing room for frequent market timing opportunities.
Alpha generators in high demand amid growing alpha potential
Above-par inflation, below-par growth, shorter economic cycles, but also new sets of opportunities might be in store in the next phase of the cycle. Amid lower potential growth and milder traditional assets’ risk/reward, alpha generators will be in high demand.
The surge in alpha since the pandemic might only be at its beginning. Following a decade of low interest rates and massive liquidity injections during the pandemic, shrinking liquidity and higher rates are a game changer. Increasing economic and asset differentiation will create more macro and micro relative opportunities. Assets will trade closer to their fundamentals as investors’ focus shifts from monetary decisions to countries’ economic situations and issuers’ quality of business models. Meanwhile, growing attention to idiosyncratic developments would give more space for thematic allocation, diversifying the sources of alpha. Finally, an above-par volatility regime would provide greater arbitrage potential and more frequent tactical opportunities.
3) Hedge funds provide sustainable diversification in a portfolio in the current environment
Resiliency in periods of macro uncertainty
Thanks to highly diversified and dynamic cross-asset exposures; the use of shorts; as well as a focus on arbitrage and relative value, hedge funds show resiliency when growth is weak.
Hedge funds are one of the few diversifying assets
The return of inflation uncertainty and stagflation risk have broken the Goldilocks negative equity/bond return correlation regime that prevailed over the last two decades.
Following record high equity/bond return correlations in 2022, the balance of forces suggests a more neutral relationship going forward. Portfolios’ risk management challenges thus remain live, while the equity/bond relationship remains unstable and poorly reliable.
The menu of diversifying assets is limited. Amongst gold, options, cash, safe-haven and real assets that all come with strings attached, hedge funds look particularly appealing.
Hedge funds show little sensitivity to traditional assets as they operate in most market segments, favour relative arbitrage with short exposures, and are dynamic in their market timing. Importantly, with an adequate rotation of strategies along the economic cycle, hedge funds provide durable diversification.
For all these reasons, we think having hedge funds in a portfolio adds value. But as risk-adjusted performance dispersion is and will be wider then, you’ll need to be selective.
We believe Amundi Asset Management can help investors with the appropriate fund selection expertise that we have developed for more than 25 years.
Bernadette Busquere,European Head of HedgeFund Research,Amundi Asset Management
Jean-Baptiste Berthon,Senior cross-asset strategist,Amundi
