Hedge Funds, PE Could Get Helping Hand From Hot Market in 2018

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The 2018 outlook for hedge fund and private equity fund returns will be determined largely by equity growth, according to several investment firm reports, although investors should be cautious as fund performance can vary dramatically.

Hedge Funds

“The hedge fund risk contribution has been fairly steady — though slowly declining — over time. Alpha generation has been deteriorating more quickly, from an annualized 8.2% in the 1990s to 0.6% annualized over the past 10 years,” states Northern Trust in its Capital Markets Review report.

(Related: Foreign Stock Markets Seen as Hot Investment in 2018)

However, rising interest rates — forecasted globally in 2018 — are a better environment for hedge funds, in general, notes K2 Advisors in its 2018 outlook: “We see subdued volatility and artificially low interest rates continuing to revert to more normalized levels in 2018. These trends have already begun to drive increased long vs. short opportunities and performance potential for hedge fund strategy investing.”

K2 continued that Global macro strategies may benefit most from emerging economic trends, “The year 2017 was a challenging one for global macro advisors as generally tight credit spreads, muted inflation expectations, unprecedented — and we believe unsustainable — accommodative monetary policy and some complacency about geopolitical risks somewhat suppressed opportunities for global macro managers.”

Long-short equity managers should be able to take advantage of the 2018 markets, especially because growth sectors that led the way in 2017 may lose attractiveness due to higher valuations and slowing quantitative easing, the K2 report states. Thus, “long-short equity managers see short-side positioning as a particularly fertile environment.” This should also be the case on the credit side.

Other hedge fund strategies that could benefit in a higher rate environment are currencies as well as commodities, “which should slowly grind higher in 2018, further strengthened by investors returning their focus to fundamentals as opposed to short-term concerns. The likelihood of a weak and relatively stable US dollar in the first half of 2018, as well as potential supply disruptions from political events in Venezuela and Africa, could also lift commodity prices,” the K2 report stated.

Private Equity Growth?

On the private equity side, 2018 could be another record year for private equity fundraising, according to Schroders’ 2018 equity outlook. Typically, private equity investors expect these funds to return long-term roughly 2-4% over listed equity returns, despite having low correlation with traditional asset classes.

Schroders expects the number of private equity funds to grow above the current 7000. That said, “The rising interest in private equity is encouraging, but this “frothy” environment also creates challenges. Some parts of the market — especially the segments where the “mega” fund managers are most active — have a lot of committed but undrawn capital, or “dry power.” 

Therefore, Schroders notes, this has led to historically high valuation levels in certain segments where many private equity general partners are competing for the same transactions. One area, for example, is pre-IPO technology companies, or “unicorns.”

Schroders states that investors should “exercise caution with regard to the risks that arrive from elevated valuations and debt levels in these segments.” It also notes that as more investors jump into the PE area, it possible that illiquidity premiums that investors have come to expect will diminish. In fact, Northern Trust has reduced the return premium for PE funds to 2.0% from 2.5% in its projections.

Schroders sees the most attractive segments for PE are 1) small and mid-sized transformational buyouts and investments, especially in Europe and the U.S. “where there is potential for organic growth or market consolidation through add-on acquisitions,” and 2) growth-oriented investments in young and fast-growing privately held technology and life sciences companies globally.

Overall, “despite valuation challenges noted, we remain positive on the performance outlook for new private equity investments in 2018,” Schroders concluded.

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