“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…” - Charles Dickens, A Tale of Two Cities.
“I have no idea what a hedge fund is, but after a day trip to Mustique, I think I need to plant one.” - Jeremy Clarkson.
“Markets can remain irrational a lot longer than you and I can remain solvent.” - A Gary Shilling.
2022 – A Story Of War And Interest Rates
“Challenging at best, brutal at worst … that was 2022 for most investors.”
2022 was pretty much as bad as it gets for traditional balanced investors. Bonds offered no offset in the face of plummeting equity markets. Moreover, many alternatives performed poorly, with the notable exception of broad commodity indices. Markets were significantly driven by the Russian invasion of Ukraine and the ensuing conflict.
Alternative Sector Returns (%)
The indices chosen above refer to listed securities.
Private markets thus far have, per their own mark to market valuations, seemed to defy the general downturn. However, based on precedence, private markets can also be expected to follow the markets down, as venture capital and growth sectors run out of cash and need further capital raises at lower valuations.
The principal lesson of 2022 was that all asset classes were impacted by the higher interest rates that hit the markets during the year, after a very long period of historic low rates.
It should be remembered that higher interest rates not alone affect the cost of capital. They also immediately impact on the rates at which assets are discounted, as we have seen recently with the collapse of Silicon Valley Bank, whose bond portfolio crashed as interest rates went up. The more recent woes of Credit Suisse are actually part of a longer story, which has been building for a number of years.
In other alternative asset classes, reinsurance is often touted as immune to both market and interest rate movements and to volatility in mainstream markets. This was only true until Hurricane Ian “barrelled into Florida” in September 2022, triggering the second costliest insured loss in US history. Unfortunately, the fact that reinsurance is uncorrelated does not mean that bad things don’t happen.
In general, hedge funds struggled not alone with the Ukraine war and higher interest rates, but also the unexpected return of persistent inflation. More broadly, the HFRI 500 Index ended 2022 with a return of -3.37 per cent after gains in the fourth quarter of 1.6 per cent. HFRI reported that the leading hedge fund strategies were macro, including the sub-strategies of fundamental commodity, discretionary and quantitative trend following CTA strategies.
The HFRI 500 Index broadly outperformed the equity and fixed income markets and especially tech stocks by 3,000 basis points, the widest margin since the index’s inception.
In 2022 hedge funds generally proved the wisdom of an allocation to alternatives when the market turns south. Within the alternative investment space, however, there were inevitably mixed returns. Bringing the whole sector down were, understandably, strategies associated with the broader equity markets, such as long-short equity.
On the other hand, any discretionary macro managers, who had managed to be ahead of the game where monetary policy was headed, (i.e. increased interest rates), performed well. Other winners were in the energy and energy transition sectors, as the war in Ukraine drove up the cost of energy and the need for investors to increase their allocation to energy security and alternative means of power generation.
Commodity funds were the stand-out sector in the period with a 41.3 per cent return in the HFRI 500 Macro: Commodity Index. According to Forbes, the only other hedge fund strategy in the green for 2022 was global macro with a weighted average return of 16.75 per cent.
In terms of allocation to the sector, geographically, Europe was the only region to record net inflows over 2022 at US$4.5 billion. The Americas and Asia based funds recorded net outflows of US$10.2 billion and US$5.8 billion respectively.
2023 – The Battle Against Inflation And The Paradox Of The “Denominator Effect”
"I never think of the future, it comes soon enough." - Albert Einstein
“In the long run we are all dead” - John Maynard Keynes
Despite the persistent challenges of a bear market, hedge funds and alternatives delivered resilient performance in 2022. In a year when the MSCI World fell 18 per cent, hedge funds captured only a small fraction of the drawdown, around 3 per cent, proving their worth as the best downside protection since the burst of the infamous Dotcom Bubble.
The reason for hedge funds’ relative success over recent years has been their ability to capture less of the market’s downside than its upside, which marks a significant change from the previous decade…and justifies the inclusion of alternatives in a balanced portfolio.
Including hedge funds and alternatives in a portfolio is not, (as often misunderstood), to generate extra alpha when the markets are booming, but rather to cover your ass when the bottom falls out of a bear market. In this regard, hedge funds and alternatives can be said to have performed their role as intended in 2022.
Additionally, 2022 marked the third straight year that hedge funds generated positive alpha, as well as the first year that hedge funds generated positive alpha in a year that the MSCI was down since 2002, i.e. indicating that the “promise” of alternatives not to be correlated to the overall market actually worked.
Paradoxically, the relative better performance of hedge and other alternative assets compared to long only bond and equity portfolios has caused investors to become overweight alternatives relative to the rest of their portfolios.
Investors, and especially institutional investors, (pensions, endowments and foundations), have, therefore, sought to rebalance their portfolios by selling alternatives…a phenomenon called the “Denominator Effect”, whereby portfolios experiencing drastic declines in other assets, e.g. bonds and equities, end up overweight the better performing assets, in this case the alternatives. Because of this, Q1 2023 has seen net redemptions of alternatives and hedge funds, and this may continue into 2023.
As we come to the end of Q1 2023, the increase in central bank interest rates to combat inflation has continued, with the most recent ECB increase of 50 basis points to 3 per cent on 15 March holding firm on the previously determined inflation busting strategy. There had been speculation that a rate of only 25 basis points would be announced.
So what can hedge funds and alternatives expect in the rest of 2023? In 2022 commodities and macro were the big outperformers, driven by the first major war in Europe in 75 years. If the war continues in 2023 one would expect these strategies to continue to do well. However, it would be a foolish person who could claim to be able to predict Mr. Putin. Recent early optimism that interest rates were now on an irreversible decline, however, have been dulled somewhat, as some sectoral February inflation figures unexpectedly showed increases.
As discussed above, listed private equity and property vehicles are already beginning to price in severe falls in valuation, but how this aligns with continuing high demand for labour in most Western countries is uncertain, if not counter-intuitive.
The fall in property potentially assumes that “working from home” will continue as before, notwithstanding that most employers are now requesting their employees to turn up at the office, even if only for half the week.
In February 2023, Barclays published their annual review of the allocator community to hedge funds. This survey represented over 300 investors with US$7.5 trillion in assets under management, of which US$660 billion is in hedge funds.
A potential paradigm shift in 2022 was the increase in retail investment in alternative asset platforms, driven largely by the rise in digital platforms, that enable investors to own stakes in art, wine, farmland, metals and other alternative assets. These asset classes have historically only been available to institutional and ultra HNWIs.
According to a recent survey by Lansons, educating investors about the case for alternatives, and building compelling and differentiated brands, is key to gaining market share in this nascent industry. Nearly 20 per cent of Americans would strongly consider investing in alternatives, and 7 per cent are already planning to do so. The biggest barrier to retail investment in alternatives is, unsurprisingly, concern about fraud and scams, by 40 per cent of potential investors.
“When any new type of investment product is introduced, it is natural that investors may be sceptical,” says John Passman, CEO of Lansons, New York.
There would, however, appear to be a significant awareness gap between older Americans and their younger counterparts. Whereas 80 per cent of Americans are unfamiliar with digital platforms, 30 per cent of Gen Z and 25 per cent of Millennials know of digital alternative platforms, or are already investing in them.
The significance of this difference in knowledge and awareness between the Gen Zs and Millennials and their parents and Boomer grandparents is that Gen Zs and Millennials are about to become the beneficiaries of the largest intergeneration wealth transfer in history.
This could see trillions of investment dollars redirected into new, sustainable industries and projects, potentially significantly using alternative investment products.
 “A Tale of Two Cities”, Charles Dickens, April 1859
 “Sunday Times”, 23 April 2006
 Forbes.com, February 1993
 “Janus Henderson Alternatives Review”, James de Bunsen CFA, 19 December 2020
 Morningstar Direct/Bloomberg, total returns to 30 November 2022
 “Janus Henderson”, ibid p.2
 Hedge Fund Research, 110 N Upper Wacker Dr 25th Floor, Chicago, IL 60606
 Forbes.com, “Commodity Hedge Funds Ruled in 2022”, 17 February 2023
 In an interview, given on Belgenland, December 1930
 “A Tract on Monetary Reform”, Chapter 3, 1923
 “Hedge Fund Outlook: the Tide has Turned”, Barclays Strategic Consulting, 24 February 2023
 …or in the case of Elon Musk at Twitter, workers must return to work full time, or resign, email from Elon Musk to staff, 10 November 2022
 Barclays, ibid p.3
 Lansons.com, “Alternative Asset Platforms: Survey of Retail Investments US”, 1 December 2022
 Lansons.com, ibid p.2
 Lansons.com, ibid p.3
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.