The prospect of continuing increases in U.S. interest rates, credit defaults and volatility has raised the hopes of hedge fund managers for a happier new year than the last.
Pensions & Investments' interviews with hedge fund chief investment officers, strategists and allocators in the last weeks of 2015 found that most expect to see wider return dispersion between different strategies and managers in 2016, after several years of return compression caused by macro factors such as zero interest rates, central bank intervention and regulation.
Likely sources of investment opportunity in the year to come, these sources said, will be differences in the pace of economic recovery between developed and emerging markets countries; high, erratic volatility; solid shorting possibilities in many securities, countries and sectors; and high-yield bond and credit distress.
There was some difference of opinion about the hedge fund strategies most likely to do well in 2016, but those cited most often by P&I sources were global macro, long/short equity, event-driven, relative value and European long/short credit.
One factor in favor of hedge fund success in 2016 is that rising interest rates have proven to be very good for hedge fund returns over the past 25 years, said Kenneth J. Heinz, president of industry tracker Hedge Fund Research Inc., Chicago.
“Depending on the level of negative correlation between equity and fixed-income returns, an increase in interest rates can be strongly positive for hedge funds,” Mr. Heinz said.
However, 2016 will start off with more of a whimper than a bang, with equity returns in the red, traditional fixed income returning 1% at best, extremely high volatility, worsening commodity prices and distress signals flaring up from high-yield bonds and other credit instruments, said Afsaneh M. Beschloss, president and CEO of hedge funds-of-funds manager The Rock Creek Group LP, Washington.
Rock Creek Group manages $10.5 billion in commingled, separate account and customized hedge fund-of-funds portfolios.
It is this gnarly combination of market snags that HFR's Mr. Heinz said will push investors, especially institutions, to “transition away from the mantra of the last five years — invest in low-risk, low-volatility, ultra-liquid, large hedge funds. A change is coming because tactical liquidity and more aggressive exposures will be needed to generate returns. Institutional investors are showing willingness to invest in riskier hedge fund strategies.”
Managers like Sir Michael Hintze, CEO and senior investment officer at CQS (UK) LLP, London, are looking closely at the possible effects of “a secular change and a structural (investment) opportunity due to the combined effects of regulation and central bank intervention,” particularly in the U.S. and Europe.
Less liquid investment opportunities will arise as banks on both sides of the Atlantic continue to withdraw from lending, and “dislocations and distortions will provide a rich opportunity set,” Mr. Hintze said in his 2016 outlook report.
CQS manages $12.5 billion in hedge fund and long-only strategies.
In 2016, the more advanced pace of economic growth in developed countries will be in even sharper contrast to woes being suffered by emerging markets nations, especially those dependent on commodity exports, said Dominic Wilson, managing director and head of strategy and research for credit hedge fund manager MKP Capital Management LLC, New York.
“The currency markets are the most natural place for hedge fund managers to express this dichotomy,” Mr. Wilson said, noting that foreign exchange will be “a core weighting for global macro strategies” that likely will find long and short opportunities between the strong U.S. dollar and the euro as well as in currencies reliant on commodities.