A decade ago, Marc Lasry, CEO and co-founder of distressed investor Avenue Capital Group, described in stark terms the impact of record low interest rates on the investment world. He told Institutional Investor that when he started in the business, a target return of 8 to 12 percent was 2 or 3 times the risk-free rate. But with rates at record lows at the time — and until recently — the amount of risk that investors needed to take to earn that same return had skyrocketed. “If T-Bills are at 25 bps, you were literally taking 30 times the risk-free rate,” he said.
Of course, that’s now changed. With the Federal Reserve’s series of rate hikes, the risk-free rate — what an investor could earn on a super-safe investment like Treasuries — hovers around 5 percent. The increase fundamentally changes the odds for hedge fund managers — for some straightforward and other more nuanced reasons.
In an interview this week, Lasry bottom-lined the changes. “Think of the problem you had two years ago when rates were zero. To generate any return, you put money in credit, equity funds, anything. You couldn’t leave your money in the bank because it was earning you zero,” he said. “Today, you’re making four and a half percent in the bank. If you’re doing that, you’re not putting money in equity funds because you’re very happy. So there is less capital in the system looking for deals. The higher the cost of money, the lower the competition.”
A deep dive into the data supports this. Almost every hedge fund strategy does better when rates are higher. In an analysis for II, hedge fund research firm PivotalPath looked at the performance of hedge funds since 2000 in low- and higher-rate interest rate environments. The rate on the 3-month T-bill was used as a proxy for the risk-free rate — that’s what an investor could earn — with almost no risk.
PivotalPath’s hedge fund composite, which includes more than 40 strategies, returned an annualized 8 percent when rates were below 3 percent and 14.6 percent when rates rose above that level. That’s an improvement of 6.5 percent per annum.
Then the hedge fund research firm calculated excess returns, which measures how much a hedge fund manager made for its investors above what they could earn by taking absolutely no risk and socking money away in a T-bill.
When interest rates were below 3 percent, hedge fund managers as a whole delivered annualized excess returns of 7.3 percent. When rates were above 3 percent, hedge fund managers produced excess returns of 10 percent. The analysis included 223 months when rates were below 3 percent and 52 months when rates were above 3 percent.
Jon Caplis, CEO of PivotalPath, said to imagine a pension fund that has a hurdle rate of 7 percent. If the risk-free rate is 5 percent, “hedge fund managers just have to generate 2 to 3 percent in excess returns to look pretty good. With rates close to zero for years, hedge fund managers haven’t been getting any help from the risk-free rate. There was no tailwind. Investors want their managers to take risk when there are opportunities in the market, not because they have no choice.”
Some of the reasons that hedge fund managers can take less risk when rates are higher are prosaic. Commodity Trading Advisors, for example, can earn the risk-free rate on the collateral they need to put up for transactions. Even before they trade, they’re now earning 4 or 5 percent out of the gate, lowering the hurdle to delivering strong returns.
Lasry explained the mechanics behind the increase in investment opportunities. A year ago, Avenue Capital was lending money in Europe at around Libor plus 8 percent. With Libor at 1, “Whoever borrowed money from us was paying 9 percent. With Libor at 4, they’re now paying 13.” While that’s good for Lasry and Avenue, they have to make sure the company can afford to pay the 13 percent. “That’s why more companies are now getting in trouble,” he said. But with less capital floating around, Avenue can be picky about the deals they choose.
When PivotalPath evaluated individual hedge fund strategies, it found that the majority do better when rates are above 3 percent. Only two of the total fail to deliver higher absolute and excess returns in those environments.
Here are a few examples. When rates are above 3 percent, multi-strat funds delivered 9.3 percent more in absolute returns and 5.5 percent more in excess returns; volatility funds returned 15.6 percent more in absolute terms and 11.8 percent more in excess returns; and credit delivered 5.35 percent more in absolute terms and 1.5 percent above the risk-free rate.
Equity strategies run by hedge fund managers, which can short stocks, also do better in rising-rate environments. Equity diversified funds delivered 8.07 percent per annum more when rates were above 3 percent, and 4.2 percent more in excess returns. Equity sector funds delivered 17.13 percent more in absolute returns and 13.28 percent more in excess returns. Caplis cautioned, however, that the high performance of equity sector funds — particularly TMT funds — when rates are above 3 percent may be attributable to the euphoria around growth stocks in general, a situation that seems unlikely to repeat itself given the comeback in value.
The market in general, of course, hates higher rates. Using the same framework, PivotalPath’s analysis shows the effect of higher rates on stocks since 2000, which is the opposite of hedge funds. When interest rates were above 3 percent, the S&P 500 had an annualized return of 2.4 percent. But when rates were below 3 percent, the annualized return of the S&P 500 shot up to 9.3 percent, an almost 7 percent difference. The excess returns above the risk-free rate — again, that’s what an investor could earn by sitting in T-bills — is 8.5 percent when rates are below 3 percent; when rates are above 3 percent, the excess return turns into an annualized loss of 2.3 percent. That’s an excess return gap of 11 percent between the two different rate environments.
Lasry said that investors understood the high risks they were taking when rates were near zero. But they had no choice. “If you are a pension plan, you have to make your 7 to 8 percent a year to pay off your liabilities.”