HSBC Review of Hedge Funds in 2013 and Outlook for 2014

By Dean Turner, Investment Strategist, HSBC Private Bank

Hedge funds reviewed
Hedge funds have delivered healthy risk-adjustedHSBC Private Bankreturns over the last few years, and have been a useful diversifier for portfolios. In our view, the macroeconomic and investing environment should remain supportive for managers across equity, credit and macro strategies.

We have been positive on the outlook for the hedge fund sector throughout 2013, believing that the sector would act as a useful diversifier in portfolios, whilst still offering decent returns. Looking ahead to 2014, we believe the asset class will continue to play an important role in portfolios, if the economic recovery continues and interest rates see further upward pressure.

Positive returns, contained volatility

So far this year, hedge funds have performed well with the HFRX global hedge fund index returning 6.4% in the ten months to October. Although equities have delivered much higher returns over this period (22% for the MSCI World Index), their volatility has been much higher. However, when compared to the performance of bonds and commodities which have both delivered negative returns so far this year, the performance of the hedge fund sector looks particularly encouraging.

This pattern of positive returns and low volatility for hedge funds is not unique to recent times. Figure 1 below shows the return and realised volatility for the major asset classes over the three years through to the end of October 2013. As should be expected, the highest returns have come from equities, but investors have endured relatively high volatility to earn these returns. For those asset classes where we would expect volatility to be lower, hedge funds outperformed bonds, as the latter has struggled against the threat of rising interest rates.

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The majority of strategies are performing well

Hedge funds have, on the whole, been able to take advantage of rising risk appetite which has been supported by the recovering global economy and extremely accommodative monetary policy. Figure 2 below shows the year-to-date performance of the main HFRX hedge fund sectors. Event driven funds, which typically focus on restructuring opportunities in the debt and equity markets, have enjoyed solid returns this year. Equity linked strategies have also delivered positive returns, likely aided by increased dispersion of returns amongst stocks.

Macro strategies have been the one area of weakness, despite the decent start to the year they enjoyed. Macro strategies were impacted by the volatility seen in equity and bond markets back in May, and have struggled to recover since.

Outlook and positioning

In our view, hedge funds should continue to perform well next year, but we expect the drivers to change. Our return forecasts for the stock and bond markets next year suggest that returns will be lower than those enjoyed in 2013 as equity valuations have less room to expand, and the threat of rising yields will likely weigh on fixed income markets. In our view, this environment should favour managers with strong stock selection skills who can take advantage of the diverging trends in earnings that we believe will be a feature of the markets next year.

Additionally, we believe that managers who can exploit relative value opportunities in the credit markets, as well as those focussed on distressed assets should be able to perform well next year as the low interest rate environment supports the ongoing search for yield.

Turning to macro strategies, in our view managers should be able to turnaround this year’s slightly disappointing performance. We believe that the recovering global economy, as well as extremely accommodative monetary policy in Japan and potentially Europe, will offer managers attractive opportunities for returns. Moreover, should tapering commence in the US, this may offer relative value opportunities for discretionary managers.

A successful 2013 and, in our view, the trends are likely to continue

Hedge funds have delivered healthy returns with relatively low volatility over the last few years. Moreover, they have been a useful addition to portfolios as their low correlation with other asset classes has increased diversification. In our view, the outlook for fixed income investments, especially in the safe haven sovereign markets, remains challenging, leading us to seek stable, low volatility returns from other asset classes. In our view, a diversified exposure to hedge funds should fulfill this role; we therefore maintain our neutral with a positive bias rating on this asset class.

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