When assessing hedge funds, it is essential to understand the impact of higher interest rates on the various strategies. With a risk-free rate of 5%, investors have options that were not available two years ago, and this is now the bogey against which managers are compared. So, do higher rates improve a hedge fund’s performance expectations, or are they a headwind? As with most things, it depends.
The Financial Times recently published a series of deep dives into the popular Multi-Strategy Hedge Fund model. With an emphasis on Citadel and Millenium Management, the FT details the impressive outpacing these managers have produced in both performance and asset growth compared to other strategies. The focus of the articles, however, was to highlight the challenges to these “Multi-Manager” approaches in the current market environment. The FT lists potential capacity constraints now that these managers have eclipsed $300 billion in aggregate. These potential headwinds include expensive talent wars, high fees, longer lock-up requirements, and regulatory scrutiny. Investor expectations are also cited now that their risk-free rate is 5% and not zero.
Even more impactful, in my opinion, is the reality of higher interest rates on strategies that require significant borrowing to achieve the necessary leverage to produce the outsized returns that investors have become accustomed to. Prime Brokers estimate that Multi-Manager, Multi-Strategy managers average 5.2 times leverage, which creates significant borrowing requirements with high interest payment requirements – i.e., headwinds.
The math works in the opposite manner for strategies that execute their trades via futures and forward markets. Higher rates for these strategies, like Global Macro and Trend Following, will increase return expectations because these instruments are cash efficient. To execute a Trend Following strategy, for example, the manager will post 10-15% of its assets on regulated Futures Exchanges and with Prime Brokers as margin to fund its positions. This means that 85-90% of its assets are available to invest in safe, interest-bearing instruments such as 3-month Treasury Bills which are currently yielding 5.46%. This interest income is then passed on to the investor, increasing returns.
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