Here’s why
In Brief
- Our historical data suggest that, on average, hedge fund excess returns (total returns minus equity beta) have risen in tandem with interest rates for 28 years, since the inception of our data set.
- To isolate the impact of this single variable—short-term interest rates—on returns, we remove the impact of equity market returns from our data history.
- What explains this observably strong relationship between hedge fund excess returns and higher rates?
- Hedge funds benefit directly from the increase in short-term rates due to cash balances and short-interest rebates, and through holding floating-rate securities.
- Also, higher interest rate environments are often associated with heightened volatility that in turn creates greater alpha opportunities.
How do higher rates impact hedge fund excess returns? The question is on the minds of many of our clients. The quick answer: On average, our hedge fund excess returns (removing the impact of equity markets) and interest rates have risen in tandem going back to April 1995, when our data set for our hedge fund complex begins (Exhibit 1). But a longer explanation of the methodology is necessary. We’ll define the chart’s terms and then look at the moving parts driving the answer.
Calculating hedge fund rolling 12-month excess returns minus equity beta
Over the 28-year track record of our hedge fund complex, short-term interest rates ranged from a low of zero to a high of 6%. While we allocate across a mix of strategies, with a strong emphasis on uncorrelated and alpha-driven investments, we have a moderate allocation to strategies that carry equity beta. Measuring the impact of higher short-term rates alone requires removing the impact of equity beta from our return history.
To do so, we calculated the trailing equity beta of our return distribution and multiplied that number by the observed MSCI World Index monthly performance; then we subtracted that from each monthly return. The exercise broadly removes the impact of equity beta from our return history while retaining the impact of our managers’ alpha.
This graph suggests that there is a material positive relationship between excess hedge fund returns, on average, and higher short-term rates.
What explains the relationship we have plotted? Two principal components drive this conclusion.
1. Short-term rates have a direct – or “mechanical” – impact on hedge fund performance.
There are several ways this occurs. In one instance, many managers hold excess (unencumbered) cash that is not required as collateral to support their positions. Such monies are traditionally invested in short-term cash, and as yields rise, those hedge funds’ returns benefit mechanically.
Another example: The short-interest rebate. In these cases, as interest rates rise and a hedge fund has been a short seller of securities, the fund will benefit from an increased payment from the lender.
Finally, hedge fund managers may invest in certain securities with floating-rate characteristics, which, all else equal, will benefit from rising rates.
The magnitude of this direct impact differs across hedge funds and hedge fund strategies, based on their margin requirements, leverage profile, approach to shorting, fees, etc. However, on average, we estimate that hedge fund industry returns will benefit from approximately 60% of the increase in short-term rates (depending on the strategy composition, manager fees and other industry characteristics).
2. The rise in short rates can potentially improve certain strategies’ opportunity set.
The second, and often more significant, way that higher short-term rates impact hedge fund performance is by creating opportunities. Broadly speaking, higher interest rates drive a rise in volatility, and higher vol is related to greater alpha opportunities. (In contrast, lower short-term rates are often associated with more robust beta opportunities and, in many cases, a reduced opportunity to add significant alpha.)
One example of why this happens: In a heightened volatility regime, stock price dispersion tends to be elevated, which provides a robust opportunity set for skilled stock pickers to benefit from both long and short positioning. In a similar vein, fear and forced trading can become more prominent in high volatility markets. This allows managers of short-term statistical arbitrage strategy funds to trade, and potentially profit from, more mean-reversion opportunities.
But our most important conclusion is this: The larger the distance grows between the black regression line and the x-axis, the greater the excess returns due to changes in the opportunity set.