Hedge Funds: Turning Positive on Tactical Trading Strategies

The hedge fund industry continued to grow in 2014. According to data provider HFR, assets under management have grown by 8.2 percent to reach a new record high of USD 2.85 trn. As traditional asset classes are becoming increasingly expensive, investors are looking to hedge funds for a reasonably stable performance. However, we think that the return prospects for the industry have deteriorated, partly due to market factors and partly due to structural factors. We would expect annual returns of 4 percent – 6 percent for hedge funds as measured by the Credit Suisse Hedge Fund Index.

Turning Positive on Tactical Trading

We have turned positive on tactical trading strategies, which are now our preferred style, followed by fundamental strategies. Tactical trading, which includes global macro and managed futures, should benefit from higher volatility levels in 2015 compared to 2013/2014. Furthermore, divergences in growth and monetary policy developments, the expected continuation of currency trends in USD, EUR and JPY, as well as lower correlations across asset classes, should create trading opportunities for this style. Generally, tactical trading strategies tend to be more resilient to difficult market conditions than fundamental or relative value strategies. Unlike for other strategies, higher volatility and low liquidity is not necessarily a negative for tactical trading strategies. In fact, managed futures have outperformed Treasuries in times of equity market corrections (see chart). Although a crisis scenario is not our base case for 2015, we still foresee conditions becoming more conducive for tactical trading strategies.

Crisis alpha: CS Managed Futures Index

Crisis alpha: CS Managed Futures Index

Positive Bias Toward Fundamental Strategies

We retain a positive bias toward fundamental strategies, although the broad market environment for this style has deteriorated. A combination of lower return prospects and strategy-specific factors are driving our view. Within this style, we prefer long-short equity and merger arbitrage within fundamental strategies. We recommend being more selective when it comes to distressed debt and emerging markets managers.

Taking a More Cautious Stance on Relative Value

Relative value is our least preferred of the three styles, mainly due to the more challenging liquidity environment. While we continue to see upside for the equity market neutral strategy, reduced liquidity poses a bigger threat for fixed income arbitrage and convertible arbitrage.