Hedge-Fund Strategies Get a Second Wind

Unpredictable forces of nature such as gusty breezes and swaying tides often trouble recreational skippers when attempting to dock their boats in a crowded harbor. A sudden rush of wind, for instance, could easily catch the bow or stern of a docking boat and blow it past the designated slip.

Seasoned boaters, however, tend to take the elements of wind and sea in stride when coxswaining in marinas. Moving with the flow, they often use the momentum and direction of moving air mass and sea waves to gently steer their vessels into narrow slips.

The idea is to harness or tame the elements in front of you to your advantage, whether it relates to docking a boat or investing. Akin to intermittent wind and tide, which can assist experienced skippers, there are exogenous factors impacting global financial markets which skillful hedge-fund managers can tap in their quest for alpha, which we define as a risk-adjusted measure of the value that an active portfolio manager adds to or subtracts from a portfolio’s return.

A number of factors—such as rising US interest rates, the recurrence of big fluctuations in global currencies, and the widening dispersion of equity returns across sectors and regions—may have helped to create an increasingly conducive environment for hedge-fund strategies, which have seen a positive turnaround in performance in recent quarters.

Over a 12-month period (ended June 30, 2017), global hedge funds, as measured by the HFRX Global Hedge Fund Index, delivered decent gains of 6.0% in US dollar terms.1 That’s a vast improvement in the performance of these alternative investments from the prior two years. Year-to-date the HFRX Global Hedge Fund Index was up more than 2.56% in US dollar terms.2 (For illustrative purposes only and not reflective of any Franklin Templeton fund performance or portfolio characteristics. Past performance is not an indicator or guarantee of future performance. Please visit our web site for most recent month-end returns)

Rising Rates a Boon for Hedge Funds

After hovering near zero for seven years, US interest rates started moving higher in late 2015.

Empirically we can observe the turnaround in hedge-fund strategy performance (since early 2016) corresponded with the rise in US interest rates. Statistical analysis of the historical relationship between interest rates and alpha supports the notion that hedge funds generally do better in a rising-rate environment. The logic is straightforward: When interest rates are rising, there will be wider dispersion of returns across different asset classes, thus creating more trading opportunities for the alpha-capturing hedge fund managers.

Alpha can be more pronounced and stronger during specific economic cycles or investment milieus, such as periods with higher interest rates. It can be weaker and insipid in other phases.

The chart below highlights the positive correlation between alpha levels (relative to the S&P 500 Index) on the Hedge Fund Research Index Fund Weighted Composite Index (HFRI FWI)3 and interest rates, as measured by the five-year US Treasury yields, over a 26-year period from January 1991 through April 2017. It shows that higher nominal interest rates historically corresponded with above average annual alpha for the HFRI FWI. For instance, when rates moved to their highest level (represented by the fifth quintile bar on the right side of the graph), average alpha levels similarly surged to the uppermost level.