2016 has proven to be another difficult year for active fund managers and stock pickers. Both institutional and retail investors have shifted more of their money away from high-profile money managers and towards low-cost mutual funds and ETFs.
Hedge Funds Vs ETFs
Since the Great Recession of 2008, hedge funds have largely underperformed broad equity indexes. In the past 60 months, the HFRI Fund Weighted Index has only returned an annualised rate of 4.23%. In contrast, the SPY ETF has posted annualised returns of 15.76% since 2011.
Hedge funds have struggled to outperform their benchmarks while central banks have adopted an accommodative monetary policy. Artificially low interest rates have flattened yield curves and subdued volatility, which active managers rely on to generate profits in both the bond and equity markets.
These conditions have taken a toll on active managers and the hedge fund industry. According to HFR, Q3 redemptions nearly tripled compared to Q2, bringing total net asset flows to -$51.4bn for 2016.
Outflows have not been this dramatic since the economic crisis when investors withdrew $131bn in 2009. Nevertheless, the hedge fund industry is still a $2.9trn behemoth, and many believe they face more tailwinds than headwinds in 2017.
Growing Political Fears
A recent survey conducted by Natixis Asset Management revealed that institutional investment firms are looking to active managers to generate alpha and to protect investments in 2017. They anticipate greater market volatility due to geopolitical uncertainty. The rise of populist movements in the UK, Italy, and the United States has created anxiety for investors.
Trump’s agenda will test market confidence as his policies are slowly implemented. Investors may also be disappointed by the time it takes for his pro-business platform to take effect. These developments will create short-term volatility that hedge funds will seek to exploit. In addition, the FOMC’s move to increase short-term interest rates in 2017 will unnerve investors.
A Rising Rate Environment
Dovish monetary policy over the past eight years has propped up the US equity market with cheap money. With a tighter monetary policy in 2017, the risk premium investors require to invest in equities may decrease. If expected returns remain the same, investors may take their money out of equities and put it where they feel properly compensated for the risks they are taking.
This could hamper equity returns and increase volatility. Significant rate increases could negatively impact corporate earnings as well. Consumers will have less discretionary income to spend due to increases in mortgage and credit card payments.
This could lead to reductions in corporate top-line growth and company valuations. Similarly, the cost of borrowing will increase, which will make it harder for corporations to service their debt.
The Tools Needed To Thrive
Since hedge funds utilise derivatives and short selling strategies, they can easily hedge against market downturns and corrections. These instruments are also better at managing risk and protecting assets that have appreciated during the bull market of the past eight years.
The fixed-income market will also face considerable short-term volatility as Trump’s pro-growth policies take effect. Investors expect the large tax cuts and infrastructure spending to boost inflation in the US. This would erode the value of existing long-term bonds, and hurt investors who are passively invested in government debt funds.
2017 will see disruptions in the market as the Fed adopts a more hawkish interest rate policy, and Trump enacts his year-one policies. Investors around the world will become increasingly wary of populist movements in the UK and Italy and as they implement their agendas as well.
The rich valuations in the equity market will be tested as economic data, and earnings struggle to meet expectations. This will create an environment ripe for active managers who can profit from corrections and market dispersion.
Active managers have struggled to compete in this bull market with their expensive fees, but as market sentiment begins to shift, strategic allocation will surely outperform passive investments.