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."