For many high-net-worth investors, hedge funds can be a valuable asset class that can help reduce overall portfolio risk and protect you against downturns. They can also be a good source of returns if you and your wealth manager choose the right opportunities.
That said, the hedge fund sector has been hampered in the years following The Great Recession by government intervention in the form of quantitative easing (QE) programs that were designed to stabilize the economy.
With the recent change in administration and today’s positive economic condition, however, we believe the government is finally backing away and allowing the markets to flow freely, which will once again allow hedge funds to prosper in a regulation-free environment.
Subdued by Government Intervention
At ICMC, we have regularly discussed the fact that hedge fund performance (i.e. long-short and diversified) has been well below our expectations during this period of heavy government intervention. We believe this is the direct result of the U.S. Federal Reserve Board (Fed) and the central banks of many other countries, manipulating money supplies in their efforts to reignite the growth of their respective economies.
The resulting impact was a tsunami of money flooding the monetary system via the QE programs, as well as the government’s own bond-buying programs. Banks were simply overwhelmed with funds which they were essentially forced to borrow from the government as treasury bill rates approached zero.
The banks then used these funds to purchase longer-term government securities (notes and bonds), while also loaning them to corporations and others at higher interest rates. This surge in demand for bonds drove interest rates to historically low levels, but also allowed banks to rebuild their capital accounts from the profits on their holdings of government securities.
Corporate borrowers would then frequently use these credit lines to borrow funds from the banks at historically low-interest rates to buy back shares of their own securities, as well as for acquisitions. Other borrowers used their credit lines to speculate in a rising equity market.
This surge in demand for equities resulted in demand for the stocks of many flawed companies (short candidates) to increase, which drove prices higher, instead of lower, resulting in losses on the stocks hedge funds sold short. It also materially offset gains on their other holdings.
This fact, together with the fact that gains in stock prices have, up to now, been so concentrated in the securities of the largest capitalization companies and specific sectors (i.e.: technology, internet retailers, and the like) created an environment where hedge fund managers have, up to now, struggled to showcase their considerable skills.
For these hedge fund managers, who are some of the smartest people in the investing business, this time of government intervention changed the rules of the game, so to speak, and fundamental analysis wasn’t working well.
Hedge Funds Now Set Free?
The good news is that economic conditions continue to improve as many QE programs ended prior to the U.S. presidential election in 2016, together with the unexpected outcome of the election itself.
In turn, performance of many hedge funds has progressively improved, as managers can now get good, deep fundamental analysis of investments as the markets and the economy normalize.
Given these changes, it is our opinion that hedge funds (particularly those employing long-short and diversified strategies) can now, potentially, deliver very good returns relative to the traditional equity markets.
Furthermore, hedge funds are likely to once again demonstrate their importance and value, particularly when the equity markets eventually correct from the current, and historical, bull market run.
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