Do the math
Institutional asset owners need to assess whether performance from a traditional 60/40 portfolio can approach target returns, Wolf said. “With 60% in equities, our internal macro and thematic team expects equity returns at between 3% and 4% over the next five years, and their forecast for interest rates is slightly over 1%. The math doesn’t work as far as trying to generate most investors’ required returns.”
These challenges make a strong case for rethinking classic asset allocation by introducing or increasing exposure to hedge fund opportunities. “Given the outlook for traditional assets, we think strategies that don’t rely on an underlying market beta or alternative risk premia in order to generate returns are the strategies that we’re really leaning into over the next several years,” Wolf said.
In this new market context, abrdn is counseling institutional investors to incorporate long-term allocations to alternatives in their core portfolios. “We are advising them to always have [a portion allocated] to diversifying strategies because if markets start to get a little bit less friendly and a little bit more volatile, one can’t suddenly move to dial up hedge fund exposures. We find that you get a pretty good bang for your buck at somewhere in the 10% to 20% range. It improves Sharpe ratios by keeping returns flat and slightly higher while risk is significantly reduced,” he said.
Consider risk-return profiles
Two traditional hedge fund strategies that exploit inefficiencies in fixed-income securities, relative value and credit arbitrage, are well poised to perform. They seem similar but offer investors different risk-return profiles.
“One approach to fixed-income arbitrage is to invest in cash bonds, then short synthetic bonds against it or vice versa. Another approach involves identifying anomalies across the curve and trading, for instance, the three-month T-bill against the two-year Treasury toward a convergence when the two-year becomes the three-month bill. This situation is relevant now because the curve is flat or even inverted,” Wolf explained. A significant subset of the fixed-income relative-value trading market is trading those two assets against each other. “Because the spreads are tight, you need significant leverage to get an acceptable return,” he pointed out.
Credit arbitrage follows a similar approach using corporate credit instruments, such as long senior debt versus short subordinated debt, or long convertible debt bonds versus short nonconvertible bonds. “It is not quite the same as fixed-income arbitrage,” he said, explaining that since “spreads are much wider on credit arbitrage, investors will not use as much leverage.”
Seize the moment
Since these types of strategies focus on anomalies along the yield curve and the relative value between assets, they benefit from market volatility and rising rates. For example, with fixed-income relative value, “higher volatility across the Treasury curve is beneficial for this strategy because it allows managers to trade [and] reset their portfolios more actively, and to monetize trades more frequently,” Wolf said.
Hedge funds can also take advantage of the market volatility that impacts long-only investors. “If there’s a flight to quality, people are looking for a safe haven in U.S. Treasuries. They’re not really considering the relationship between the front end of the curve and the back end of the curve. It might be uneconomic, but its what’s in their immediate best interest,” he said, which creates opportunities for managers who can act on spread anomalies.
The impact of higher rates can be beneficial as well. “At this point in the cycle, as interest rates reset higher, spreads on fixed-income relative value and rates trading also widen. When yields are higher, similar parallel curve shifts lead to more magnified changes that create juicier spreads through which managers can find opportunities,” Wolf added.
Proceed with caution
While relative value and credit arbitrage offer enhanced returns, investors need to be cognizant of potential risks of overuse by managers — making manager selection a key consideration. “Asset owners need a manager who understands and respects risk management, especially in fixed-income relative value. As the position moves against expectations and the spread widens, it looks theoretically much more attractive. It is easy to say, ‘I like the spread at X and I love the spread at 2X,’ which can motivate managers to load up on risk if they are not disciplined.”
Widening spreads are an opportunity or a risk. “It doesn’t mean you should immediately sell if spreads widen. It just underscores the importance of having risk frameworks and protocols in place,” Wolf said.
For investors looking for an optimal path to proceed, both active and passive approaches can be viable. “Path one is [for] firms like abrdn to find the best individual managers within themes like merger arbitrage or fixed-income arbitrage. We do due diligence, cast a wide net and find the best managers in the space,” he said. Alternatively, “investors could passively invest in an underlying strategy benchmark tied to these hedge fund approaches and eliminate single manager risk, while providing a type of pure exposure to these strategy themes.”
Watch the spread
Another traditional hedge fund strategy well suited for the current market environment is merger arbitrage, a spread strategy based on the convergence of corporate equity securities. Wolf offered an illustration: “Suppose GM was buying Ford. At some point, the two stocks become one stock and one ticker, which is the expected convergence. One collects the spread derived by purchasing the stock being acquired and then shorting the acquiring stock. Investors will likely lose money if the deal doesn’t close because things will trade back to pre-deal levels.”
Merger arbitrage does well when rates rise. “The higher the interest rates, the bigger the discount rate and the more significant that spread will be before the deal closes. Merger arbitrage, historically, has done very well in rising and high-interest rate environments for that reason,” he noted, adding that current spreads are also attractive.
“Merger arbitrage is considered a low-risk strategy. Investors usually get steady high single-digit returns — 7% and 8% — in this environment as interest rates go higher and the markets are more volatile,” Wolf said.
Investors need to be cognizant of the strategy’s unique risks. The strategy “seems fairly straightforward, but it is not just one buying the target and shorting the acquirer. Certain deals are much more complex. [For instance,] deals with collar structures can hide how much the acquirer is paying. And cross-border deals add complexity that [can be] really tricky.”
The profile of a merger-arbitrage deal is short volatility. “It is described as picking up nickels and dimes in front of a steamroller, which sounds kind of scary, but that’s the profile,” Wolf said. “You can make a small amount of money 97% of the time when deals close, but then that one time that a deal breaks, you could wipe out the money that you made on the previous [several] deal closings, something that investors need to appreciate fully. That doesn’t make it a bad investment approach, but investors must understand the risk-return outlook.” ■