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Finally, some good news for hedge funds

Hedge fund performance suffered over most of the bull market, burdened by poor decisions, a bad reputation and the rise of passive investing. Hope, however, may be on the way.

A factor often overlooked in how hedge funds have managed during the market and economic recovery is that interest rates have been at historic lows.

The Federal Reserve dropped the rate it sets for banks to borrow from each other to near zero amid the financial crisis, and left it there for seven years. Even now, the U.S. central bank has enacted just two quarter-point hikes since December 2015.

Looking out over time, there has been a direct correlation between monetary easing and poor hedge fund performance. Analysts at the Wells Fargo Investment Institute mapped it out in a note sent to clients.


Source: Wells Fargo Investment Institute

Before the easy money that central banks began delivering after the financial crisis, the correlation was almost exact. During the era of zero-interest policy, hedge funds' performance, as measured by the HFRI Fund Weighted Composite Index, consistently underperformed the S&P 500 market benchmark.

That could change this year.

The Fed is expected in 2017 to make significant strides toward normalizing policy. According to the most recent projections from the Federal Open Market Committee, the bank's policymaking arm, 2017 could see three interest rate hikes. Traders in the fed funds futures market expect no more than two.

"Interest rates, specifically the federal funds rate, may be a more pernicious, yet often overlooked, influence," Justin Lenarcic, global alternative investment strategist at Wells Fargo, said in the note. "We anticipate an improvement in hedge fund performance as the federal funds rate moves higher."

Tourists pose in front of the iconic Wall Street Bull near the New York Stock Exchange.
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Tourists pose in front of the iconic Wall Street Bull near the New York Stock Exchange.

History bears out that line of thinking.

During the January 2001-May 2004 easing cycle, the HFRI index saw four-year annualized returns fall from 13.4 percent to 6.4 percent. Similarly, the most recent easing cycle saw four-year returns drop from 11.5 percent to 4.5 percent, as measured from September 2007 through November 2015, Lenarcic said. Four-year annualized returns were used because that is the average length of the most recent monetary policy cycles.

By contrast, the hiking cycle from June 2004 through August 2007 saw hedge fund returns almost double, from 5.7 percent to 11 percent.

"We believe that there may be multiple reasons why hedge fund performance improved as the federal funds rate rose," Lenarcic said. "For instance, managers likely benefited from stronger economic growth, higher inflation, more carry (or yield) from fixed income positions, and an increase in both volatility and trends in global credit and equities."

Those conditions sound an awful lot like what many on Wall Street are expecting ahead.

Though Fed expectations for growth are fairly muted, many economists have been ramping up their projections to see gross domestic product jump to 3 percent or more after nearly a decade of sub-2 percent growth. Inflation is supposed to pick up as well, and government bond yields have been on a consistent climb since bottoming in early July.

Volatility is expected to pick up as well. The Fed-induced low-volatility climate has made it difficult for stock pickers to find mispricing opportunities as correlation in stock movement has been high and dispersion, or the difference between returns for various sectors, remains comparatively low.

"While it may be tenuous to claim that a rising federal funds rate can lead to greater dispersion in equity-market returns, we do believe that (loose) monetary policy has the tendency to reduce return dispersion and partially mitigate the benefits of security selection," Lenarcic said.

The potential for more favorable conditions comes at a crossroads for hedge funds.

The industry just passed the $3 trillion mark for total assets under management, even though investors pulled more than $100 billion during the year. Positive performance, with the HFRI index notching a 5.5 percent full-year gain, helped nudge total assets higher.