Dr. Sushil Wadhwani recently participated on Mercer’s Critical Thinking, Critical IssuesSM podcast. In the episode “Hedge funds: the comeback kid?” Dr. Wadhwani joined Mercer’s Alternatives Investment Director Deborah Wardle and CIO-Hedge Funds Dave McMillan to discuss the historic challenges of today’s macro landscape and whether we are seeing a comeback for hedge funds. [Dr. Wadhwani’s direct quotes appear in italics]
What are the biggest concerns about the current market environment?
“What happens next is very unsettling because it’s been a long time since central banks have been this far behind the curve. It’s very difficult to soft-land the economy starting here, so the risks of a recession must be very high.” Today’s macro scenario mirrors that of the late 1970s and early 1980s. Inflation has been higher and more persistent than any of the central banks thought, and has become compounded by geopolitical events. It’s clear that inflation expectations have become de-anchored and that the central banks are behind the curve. In this situation, central banks have to tighten aggressively, which they all are signaling they will do.
Central banks have few policy options as they can’t allow inflation expectations to be permanently de-anchored. This is starkly different from the economic landscape of the last 20 years when inflation was persistently low. Virtually every time financial conditions tightened and equity markets fell, central bankers rode to the rescue. Today we’re faced with a situation where bond yields are going up because inflation is high and central banks are tightening, while equity markets are threatened by both higher interest rates and the prospect of a recession. “It’s actually quite a lethal and unhelpful combination, which then means that the 60/40 portfolio is significantly challenged, just as it was in the 1970s.”
How can asset owners protect their portfolios amid this volatile environment?
In this uncertain environment where equities and bonds are increasingly correlated, the need for diversification is palpable. Portable alpha approaches are very well suited to today’s challenging investment landscape because of their low correlations with equities and bonds and the fact that there is some return being produced, somewhere in the neighborhood of cash plus 4%. So, the diversifying role these approaches can play in portfolios is as an equity risk mitigator. For example, replacing a passive equity allocation with equity futures frees up cash that is then invested in a diversifying strategy. This produces the return of the equity index plus a little extra alpha, and importantly, mitigates the equity risk. So essentially, this allows investors to “put some insurance in place, but that they’ve put this insurance in place without it actually costing them any money.”
What are the key areas of opportunity in the hedge fund market today?
We look to be transitioning from a macro environment where inflation was low and central banks could continually ride to the rescue, to one of a significant inflation regime change. And amid regime changes, central bank interest-rate-setting committees tend to demonstrate inertia. Similarly, investors demonstrate inertia because it’s difficult to tell whether a regime change actually has occurred. “And that’s a perfect environment for a hedge fund strategy like trend following to do well. Trend following does best when it’s exploiting inertia. And if trend following does well, then systematic macro and discretionary macro, which are country cousins of trend following, are also going to do well.”
There’s a well-above-average probability of a recession in the US and the UK in the next two years, and that represents a significant discontinuity in economic behavior. Again, trend followers are great at exploiting discontinuities. The combination of regime change and recession risk should make strategies like trend following, systematic macro, and discretionary macro attractive.
What are the biggest risks to the hedge fund market?
It may be that the macro scenario is much better than I’m imagining, that supply constraints might ease, inflation may suddenly start declining, and markets may settle down. If this were to happen, the trend following positions that have prospered this year may
suddenly reverse. At that point, the challenge will be discerning if what we’re seeing today is a bull market correction or a secular change, and are we likely to revert to the benign macro environment of the last 25 years? “And that is certainly something that is going to challenge hedge funds of various types because increasingly, a more uncertain macro environment has impinged into the thinking of people who do all sorts of different things under the hedge fund label.”
What are the ‘big disruptors’ in the hedge fund space?
As in most fields, technology has been the great disruptor and transformer. For hedge fund managers in particular, the availability of data has been immensely advantageous. Whereas in the past we relied on aggregates that came out weekly or monthly, we now can access daily information, which is instrumental in tracking economies and sentiment shifts. But despite the vast availability and access to data and automated algorithms, knowledge of economic theory is still crucial to understand the differences and the context of relationships in the market. “There are lots of fears that humans like us might get disrupted because of automated machine learning and artificial intelligence and so on. Now, the only thing that saved dinosaurs like me so far is the fact that economics is not physics and actually there are very few stable relationships in economics. So, while I’m not ruling out the possibility that there may be some very clever machines that ultimately replace us, we’re not there yet.”
To hear the entire podcast please visit https://www.mercer.com/our-thinking/wealth/podcast-critical-thinking-cr…