The effect of interest rates on the stock market has taken center stage in recent months, as President Donald Trump has not held back on his view that Federal Reserve Chairman Jerome Powell has curtailed U.S. economic expansion. Powell’s actions likely also caused institutional investors, such as public pensions and college endowments, to reexamine their exposure to public markets, and consider allocations to alternatives such as hedge funds, which are often considered a defense against interim monetary policy changes.
Indications of a rate cut at the next Fed meeting on July 31, strongly hinted at by Powell during his recent two-day testimony to the House Financial Services Committee and Senate Finance Committee, have the full attention of Wall Street traders. The impending cut should also have the full attention of hedge fund managers and the allocators to these funds.
While it may seem odd that central bank policy holds so much sway over hedge funds, looking at years’ worth of data on over 40 unique strategies employed across multiple asset classes, proves otherwise.
We evaluated hedge fund industry returns within our Composite Index (which includes 1,150 hedge funds, representing over $2 trillion in assets) over the past 20 years while controlling for interest rates. By doing so, we observed a meaningful relationship between interest rates and aggregate hedge fund performance. Specifically, the perceived decline in performance is significantly reduced when we correct for returns in excess of the risk-free rate — the interest that an investor would expect from an absolutely risk-free investment over a given period of time.
Critics of the hedge fund industry have wasted no time in attributing recent weaker hedge fund performance to a number of factors: capital flooding the marketplace, fee-greedy managers, or the rise of passive management. The list goes on. But this one piece of the puzzle — the effect of interest rates to overall manager performance — is less well-covered, either because most parties lack access to high-quality data or the tools to analyze it.
Our analysis shows that it is clear that hedge funds perform best when rates are higher or rising (but not at too fast of a rate change). When rates are between 2 percent and 4 percent, there is a positive correlation to overall asset class performance. Once rates reach 2 percent or below, particularly as part of a negative swing on rates, hedge fund performance declines. A partial explanation for fund managers is that when rates are higher, they get better compensated on the cash generated from shorting stocks. And a lower rate is not ideal for the hedge fund composite — to date, when rates fall in a given year, hedge funds have not done well.
If excess returns remain relatively constant, it follows that managers’ skills and opportunities should persist. In fact, in a higher interest rate environment, investors should expect a commensurate increase in absolute returns. In either a high or low interest rate environment, investors should always strive to separate those who generate quality alpha from the rest of the pack.
It is clear that interest rates, and Powell, have much more power over the hedge fund industry than is commonly acknowledged. And we will soon learn if he will be considered a friend or foe to the industry. Just as traders are anxiously awaiting guidance on rate cuts, it would be wise for hedge fund managers to start pricing in a potential cut to their respective strategies.
Lastly, regardless of the rates, institutional investors are always better suited by spending the time to find the right strategies that perform best during monetary policy shifts. And selecting the most skilled managers within those strategies.
Jonathan Caplis is the Founder and CEO of PivotalPath, a New York-based research and intelligence platform for hedge fund allocators and managers.
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