Hedge funds: A new golden age?
Downside protection during volatility
Markets have entered an 'age of anxiety'. I think we are going to see an extended period in which investor sentiment swings between extremes of optimism, anticipating a return to normality, and pessimism, worrying that the recent pandemic will have damaging economic, social, and political after effects that will persist longer than expected.
Investors should be diversifying their portfolios to deal with a coming era of heightened economic uncertainty and market volatility, but this does not mean that we are mired in a deep economic depression or extended bear market.
Quite the contrary. Investors with a long horizon should do well with equities. But - and this is an extremely important but - in the intermediate term it will be very difficult to generate meaningful returns in conventional asset classes.
Investors must make room in their portfolios for alternative investments because their ability to hedge can provide much needed downside protection and diversification during volatile times for equities.
Hedge funds have the potential to be an important alternative to fixed income particularly since government bond yields are at rock bottom and remain vulnerable to increasing inflation.
The pandemic is not only a once-in-a-lifetime shock to the global economy but also a critical inflection point for markets.
Although a new phase of monetary easing is underway, accompanied by fiscal stimulus, especially in the US, we are in completely uncharted waters. Market moves also have been unprecedented. Stocks plunged into a deep and sudden slide in March, only to rebound just as dramatically in April and May.
The case for hedge funds in the throes of a crisis
But does this mean we are back to normal? Of course not. We have yet to see the full impact of the pandemic on the economy.
Consequently, investors who believe that the downdraft in corporate earnings is only a brief interruption of the prior trend are opening themselves up to potentially significant risk.
The radical shift in the investment environment requires a change in investors' thinking. During the bull market, liquidity and low interest rates dampened volatility, so 'buying the dip' and sticking with high-momentum stocks were the keys to outperformance.
For the foreseeable future, though, I think that strategy will struggle, because uncertainty about economic fundamentals will outweigh liquidity and low interest rates.
Covid-19 is not the real issue - volatility and market disruption are. Covid-19 may have been the catalyst for the most recent bout of volatility and market disruption, but throughout the past four decades of financial history, one key role for hedge funds has been to provide diversification for investors' overall portfolios by dampening the downside.
It is fair to recall that hedge funds as a group underperformed over the past ten years, but, by definition hedge funds shouldn't be expected to outperform the indices in a bull market to the extent that they do hedge.
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