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Could a nuanced hedge fund allocation save you when US rates rise?

In recent years, we have seen central banks in the US and Europe take drastic action to boost their economies in the wake of the global financial crisis. Low or negative rates have been implemented along with quantitative easing (QE or printing money) on a massive and unprecedented scale.

In this superficially low risk environment, we have seen – rather unusually – equities and bonds performing strongly at the same time. But what goes up must eventually come down.

When interest rates are raised in the US – expected by many to be in December this year – we will see the safety net from cheap money withdrawn. Bonds, equities and even property could all fall in unison, reversing much of their gains over the previous months.

Certain hedge fund strategies should be able to help. This may sound like unusual advice. After all, hedge fund returns in recent months have been mixed compared to those of bonds and equities. But certain hedge strategies have been shown to outperform in such an environment.

Take global macro for example. This strategy buys and sells global equities, bonds, currencies and commodities based on the political and macroeconomic outlook of different regions.

To illustrate the performance of global macro strategies, we use the Aberdeen discretionary macro peer group, which is an equal weighted index comprised of 116 discretionary macro hedge funds (as of 31 August 2016).

This index has consistently outperformed bonds over the last 15 years. Importantly, the returns from these global macro funds are currently exhibiting the highest negative correlation to bonds for 15 years. This can partly be attributed to a growing sense among macro investors that bonds may be overpriced. Fund managers are therefore adopting positions that would benefit from a rise in interest rates.

They are also preparing for the potential impact that higher inflation will have across other asset classes. In foreign exchange, managers anticipate a rally in the US dollar, driven by a central bank (the Federal Reserve) looking to keep inflation in check. In commodities, managers see real assets like gold benefiting from a slow central banking response and increased fiscal spending, resulting in rising longer-term inflation expectations.

Global macro, relative value and trend following are strategies that are likely to perform well during periods of rising interest rates.

Beyond global macro, relative value (RV) and trend following are other strategies that are likely to perform well during periods of rising interest rates.

Strategies that trade RV opportunities in equities and fixed income can benefit in two ways. Firstly, they tend to operate with high cash balances as the purchase of securities is financed from proceeds of short selling other securities. Higher interest rates mean higher income on cash balances, which contributes to overall return. Secondly, an increase in interest rates would likely be accompanied by higher volatility in markets. And with greater volatility comes greater opportunity, both in terms magnitude and frequency.

On the other hand, trend-following strategies aim to predict future prices through analysis of historical market and price data. The current environment of rising inflation will drive strong trends across a wide range of asset classes, putting pressure on bond markets, boosting commodity prices, and leading to large divergences within the equity market depending on each equity sector’s sensitivity to interest rates. For example, higher interest rates would be positive for banks, which can charge more for lending, but negative for real estate investment trusts (REITS). Managers aim to identify these price trends, both positive and negative and position themselves to benefit accordingly.

Looking at the hedge fund industry as a whole, there has been significant evolution in recent years. A growing adoption of alternatives by institutional investors has brought with it important changes. While previously, hedge funds were predominantly accessed via unregulated offshore vehicles, today there is a rapidly growing universe of funds implementing alternative strategies through onshore structures.

Under the 40 Act regulations in the United States, and under UCITS regulations in Europe, these funds now offer greater transparency, regulatory oversight and ease of dealing, for both institutional and individual investors. These developments have made hedge funds more accessible and attractive to institutional investors.

There’s clearly going to be winners and losers – we know that much. And so investors looking to navigate through the impending US interest rate rise will need to be well prepared. A carefully thought through allocation to specific hedge fund strategies may help to weather the storm.

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