Hedge Fund Outlook Sees a Fertile Ground for Alpha Capture OpportunitiesDec 1, 2017

2018 Outlook: “We see subdued volatility and artificially low interest rates continuing to revert to more normalized levels in 2018. These trends have already begun to drive increased long vs. short opportunities and performance potential for hedge fund strategy investing.”

Several key market factors appear to us to be at or near inflection points as we approach 2018. Global interest rates seem poised to rise further as major central banks strike increasingly hawkish tones. Central banks have also begun to provide more guidance around curtailing their prolific quantitative easing over the next six to 12 months. Inflation expectations have begun to reset to the upside, led by global growth, including China’s resilient economy. Proposed US tax reforms face important milestones in the near future. Even investor concerns have started to migrate from the strength of global growth to more focus on regional geopolitical risks.

While these developments may affect hedge fund strategies differently, alpha1 for the hedge fund universe has historically strengthened in these environments, particularly when interest rates rise.

On Average, Higher Interest Rates Historically Have Benefited Hedge Strategies’ Alpha

Hedge Fund Alpha at Different 10-Year US Treasury Yield Levels
Calculated on 12-Month Forward-Looking View
January 1991–October 2017

Average Yield Quantities

Quantities Average Annualized Forward Looking (12M) Alpha

Source: Bloomberg. Data as of 10/31/17. Alpha calculated relative to the S&P 500 Index. Past performance does not guarantee future results. Important data provider notices and terms available at www.franklintempletondatasources.com

An Emerging Tailwind in Global Macro

Global macro represents one strategy where we see significant potential from emerging economic trends. The year 2017 was a challenging one for global macro advisors as generally tight credit spreads, muted inflation expectations, unprecedented—and we believe unsustainable—accommodative monetary policy and some complacency about geopolitical risks somewhat suppressed opportunities for global macro managers.

What a difference one year makes.

As we approach 2018, policy activity across four major central banks—the US Federal Reserve (Fed), European Central Bank, Bank of England and Bank of Japan—and a number of smaller players presents opportunities for discretionary macro managers, in our view. We see heightened investor focus on major central bank policies. As a result, currencies could continue to offer meaningful performance dispersion over the next few months in this environment.

Economic Trends Support More Robust Opportunity Sets across Strategies

Meanwhile, commodities also stand to benefit from continued economic expansion and a potential reversion to higher historical prices. We believe commodity prices should slowly grind higher in 2018, further strengthened by investors returning their focus to fundamentals as opposed to short-term concerns. The likelihood of a weak and relatively stable US dollar in the first half of 2018, as well as potential supply disruptions from political events in Venezuela and Africa, could also lift commodity prices.

Long short equity is likely to see support from rising interest rates in 2018. Fundamentally weak companies typically face increased pressures on their financials in a rising interest-rate environment, allowing managers to potentially benefit when they can correctly pick winners while hedging out general market risks through short positions. Further decreases in stock correlations also contribute to our favorable outlook for long short equity. Investors have largely begun rotating into the financials, insurance and industrials sectors—areas that we anticipate drawing more interest in 2018. In contrast, many of the growth sectors that led equity market performance during 2017 through October hold less appeal to us due to higher valuations and slowing quantitative easing. With tighter financial conditions likely, long short equity managers see short-side positioning as a particularly fertile environment. Long short managers on the credit side have also found attractive short opportunities that we believe could continue in 2018. For example, with retail store closings persisting and higher interest rates weighing on the ability of retailers to refinance, we may see some weakness in commercial mortgage-backed securities.

In the insurance-linked securities (ILS) space, several tragic and extensive disasters affecting the United States and US territories have resulted in meaningfully higher yields amid broad investor pessimism. However, we believe in some cases, investor concerns surrounding ILS may be overstated. For example, insurance losses in the Houston area may be substantially less than anticipated, as the area has a very low level of residential flood insurance coverage. Nonetheless, we began to see increased volatility in catastrophe bond prices and increased demand for shortfall reinsurance coverage in the second half of 2017, which could strengthen ILS performance potential going forward.

The Importance of a Tactical and Diversified Approach

As we mentioned, the dynamic environment we see unfolding is unlikely to affect all strategies the same way. Although long short equity and global macro may stand to benefit, event driven managers may encounter headwinds. The potential for further central bank interest-rate hikes, inflation swings, a surge in US Treasury yields from Fed action, or ambiguities surrounding proposed legislation could reduce the attractiveness of mergers and acquisitions. In addition, proposed US tax reform could result in the elimination of certain interest expense deductions, which could dampen private equity activity. On the positive side, we see potential regulatory changes and the possibility of a tax holiday on corporate repatriation of cash from overseas as potential developments that could support event driven managers.

We remain cognizant of other potential challenges that may arise in 2018. Global growth could be impeded by a central bank making a policy mistake, such as raising interest rates too aggressively with regard to timing or frequency. For event driven managers, a significant central bank miscue or increase in cross-border or monopolistic regulatory constraints could complicate and potentially unravel mergers and acquisitions. Geopolitical risks also remained as of late 2017: tensions surrounding North Korea, the potential for heightened discord among US legislators, developments in the Brexit process and Catalonia’s secession efforts in Spain.

Finally, we believe a continued focus on managing downside risk is a key consideration entering 2018. From our perspective, the performance of hedge fund strategy investing in 2018 could be driven more by alpha (or fundamentals-driven) contributions and less so from market sensitivity (or beta) influences.