Hedge funds have shown their value in protecting portfolios during times of significant market volatility, as seen in August 2024.
UBS analysts in a note flagged that hedge funds, especially those using non-directional strategies, took advantage of market disruptions while also protecting against losses in stocks and bonds.
With ongoing market uncertainty, hedge funds are becoming more important for managing risks, boosting returns, and handling unpredictable economic conditions.
Contrary to expectations of a quiet summer, August 2024 delivered significant market turbulence. A combination of thin liquidity, weak U.S. economic data, and geopolitical concerns led to heightened volatility.
The volatility index surged, and global equities experienced sharp sell-offs, with the U.S. 60/40 portfolio declining by 3.1% in just three days, according to UBS analysts.
Japan's Nikkei 225 also saw a dramatic 20% decline, underscoring the fragility of global markets.
“However, early August brought market jitters against a backdrop of thin liquidity due to weak US jobs and manufacturing data, sparking concerns of a "hard landing.," the analysts said.
The unwinding of leveraged positions, especially in Japanese markets, exacerbated the situation and led to significant sell-offs across asset classes.
While traditional long-only portfolios suffered due to heightened correlations between equities and bonds, hedge funds excelled by offering uncorrelated returns and seizing opportunities presented by volatility.
UBS flags that hedge funds with lower market exposure, including those employing equity market-neutral and alternative credit strategies, significantly outperformed during August's market swings.
Convertible arbitrage strategies, which benefit from long volatility profiles, gained 1.1% in August by capitalizing on sharp reversals in market sentiment.
Similarly, fixed income relative value strategies and credit hedges contributed positively, with UBS noting that many managers were able to monetize gains from widened spreads before markets rebounded.
Hedge funds not only offer downside protection but also thrive in environments characterized by market dislocations.
UBS analysts stress that during periods of volatility, prices often deviate significantly from their intrinsic values, providing hedge fund managers with unique alpha opportunities.
By taking contrarian positions—buying undervalued assets or shorting overvalued securities—hedge funds can profit as prices revert to their natural averages once markets stabilize.
UBS points to the success of discretionary macro strategies, which navigated August's turbulence by capitalizing on moves in global currency and bond markets.
One of the key advantages hedge funds offer is their ability to provide uncorrelated returns during periods of market instability.
As correlations between asset classes rise during times of stress, portfolios comprising traditional assets like stocks and bonds become more vulnerable to simultaneous declines.
Hedge funds, however, are designed to exploit inefficiencies in the market and take advantage of price dislocations, rather than simply riding broader market movements.
As per UBS, strategies such as global macro, equity market-neutral, and multi-strategy funds have been particularly effective in delivering uncorrelated returns, helping to smooth out portfolio performance and reduce overall risk. These strategies allow investors to maintain exposure to high-risk markets while mitigating the impact of sharp sell-offs.
UBS analysts foresee continued volatility in the coming months as central banks adjust monetary policies, and geopolitical risks remain elevated. While inflation concerns have eased, economic data continues to fluctuate, and the path of future Federal Reserve rate cuts remains uncertain.
Meanwhile, the looming U.S. presidential election is expected to bring further political uncertainty, which could drive market swings.
Given these factors, UBS recommends that investors incorporate hedge fund strategies into their portfolios to prepare for future volatility.
Low net equity strategies, alternative credit, global macro, and multi-strategy funds are seen as well-positioned to help investors manage risks and capture opportunities as markets evolve.
While hedge funds present significant opportunities, UBS also emphasizes the risks associated with these investments. Hedge funds are often illiquid and may require long-term lock-up periods.
Additionally, their strategies can be complex, and investors should be prepared for potential losses, especially when leverage is employed.
As such, UBS urges investors to approach hedge fund investments within the context of a well-diversified portfolio and ensure they are comfortable with the associated risks.
