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When Inflation Is High, Hedge Fund Managers Thrive

Historical data suggest inflation-flustered investors could build a diversified portfolio of hedge funds to protect themselves.

The first serious signs of inflation appearing in decades have investors concerned — but rising prices and interest rates may be a good thing for hedge fund managers and investors that hold diversified hedge fund portfolios.

Hedge funds as group have historically thrived during different points in the inflation lifecycle, according to new analysis from PivotalPath. The research firm analyzed 23 years of market and proprietary hedge fund data to determine the effect of inflation on different hedge fund strategies. 

Inflation can hammer a portfolio as businesses pay higher wages and higher prices for supplies and as bonds issued at low yields fall in value. At the same time, investors fear that the Federal Reserve and other central banks may curb their loose monetary policies, including raising the low interest rates that have fueled the market’s gains for years.

But PivotalPath found that once interest rates reach an elevated level, about 3 percent in the study, all hedge fund strategies, tracked as a group, significantly outperformed the S&P 500 index. 

Then when rates move back down, all hedge fund strategies outperformed equities along the way.

The PivotalPath Hedge Fund Composite Index, which represents all strategies tracked by the firm, returned an annualized 9 percent compared to the S&P 500’s 1 percent return during those same periods. In its research, PivotalPath used the 10-year Treasury rate as a proxy for inflation, because a yield increase on the note indicates that the market expects inflation. 

Jon Caplis, CEO of PivotalPath, said the starting point for the research was determining what happens to both the S&P 500, as a proxy for equities, and hedge fund strategies in general during two different periods of time: while rates are rising and once the level of rates becomes high. 

“Conventional wisdom is that high rates are bad for equities,” Caplis said. “First it’s more complicated than that. And second people don’t generally study what happens to hedge funds.”

Hedge Funds Outperform When Rates Are High — And Falling

When rates were low — between 0 and 3 percent on the 10-year Treasury — the S&P 500 returned 16 percent annually, according to PivotalPath. When rates were high — between 3 and 7 percent — the S&P 500 returned 5.2 percent annually. That’s a difference of 10.9 percent. 

By contrast, PivotalPath’s hedge fund composite index returned 7.8 percent annualized when rates were low, and 12.2 percent when rates were high.

While periods of high rates aren’t great for equities, it’s a different story along the way up, according to the research firm. In that case, equities are generally good performers. That sets up a tough benchmark for hedge funds to beat.

PivotalPath then studied the periods when rates are moving. It found that when yields were rising in a given month, the S&P 500 returned on average 20.9 percent annualized. When rates were falling in a month, PivotalPath found that the S&P 500 returned 1.2 percent annualized. Meanwhile, PivotalPath’s hedge fund composite returned 11.9 percent when rates were increasing and 8.8 percent when they were on the decline. 

“Overall, a diversified hedge fund portfolio does pretty well. It doesn’t outperform equities when rates are rising, but it holds its own,” Caplis said. “The kicker is when rates fall, hedge funds do really well, and over time you could outperform the S&P by 800 basis points when the S&P is kind of flat.”

While hedge funds might underperform when the S&P 500 is up significantly, “you’d take that trade all day long, because of that downside protection in a month like March 2020 and in an environment where there is so much uncertainty,” Caplis added.

Caplis explained that hedge funds can thrive in a high-rate environment as well. That’s because of tail winds embedded in hedge fund strategies, such as collateral earning a higher rate and hedge funds getting paid to borrow stock. “That works at exactly the time where conventional wisdom says when rates are high, equities have trouble,” he said.

But equity hedge funds don’t face the same trouble, according to PivotalPath. Investors concerned about rising rates and inflation can turn to energy and financials equity sector funds, event-driven managers, and credit hedge funds, among others. The research firm’s equity diversified index returned 16.4 percent during these periods; equity sector funds returned 19.8 percent; and event-driven funds generated 16.4 percent.

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