Hedge funds – an effective tool for volatile environments

Rayhaan Joosub, Sentio Capital Management

We are entering a precarious time for financial markets with global growth slowing and central banks focused on bringing pandemic and war-induced inflation under control by raising rates. Tightening financial conditions and a slowing growth environment increase the risk of a global recession.

Bond markets have already begun repricing this new economic regime with aggressive sell-offs in risk-free yields and increased credit spreads. While equity markets have corrected somewhat, equity market volatility has so far been muted since company earnings, up to now, have been robust against tightening financial conditions. With economic uncertainty high and further monetary policy tightening, we expect equity earnings to eventually come under pressure and result in higher equity market volatility going forward.

 In addition, bonds, which have been a traditional safe-haven and hedge against equity market drawdowns, are unlikely to behave the same way as they have in the recent past due to higher inflation. Therefore, investors will be challenged to earn absolute returns in this environment. 

We believe that hedge funds could be the answer to this predicament.

Return asymmetry and capital protection
In order for hedge funds to thrive in this environment, they must be able to adapt to the current regime of higher volatility and higher stock-bond correlations. First and foremost, they must be able to protect capital during equity market drawdowns. To make money, you need to ensure you don’t lose it in the first place.

Hedge funds need to therefore: 
i) be nimble in managing the net risk exposures in response to equity market moves, 
ii) use derivatives to achieve an asymmetric return profile and, 
iii) short stocks effectively to hedge market downside risk. 

A combination of the above three strategies is crucial to avoid drawdowns and thus also ensure that a fund is on the front foot and able to take advantage of attractive market opportunities when they present themselves. After all, it’s important to be greedy when others are fearful and thus a well-implemented capital-protection strategy can allow a hedge fund to take advantage of these opportunities and generate absolute returns even when markets are down or going sideways. 

Too many hedge funds operate as leveraged plays on risk assets, performing well on the upside when the going is good, but they perform equally poorly in declining markets. Hedge funds should perform well in rising markets, however they must at least also protect capital in falling markets. Therefore, an asymmetric return profile is a crucial ingredient to any good hedge fund. 

Uncorrelated returns – alternative strategies

Mean-reversion strategies are another important aspect that hedge funds can take advantage of during high market volatility, as they typically do well in these types of regimes. High market volatility leads to excellent arbitrage opportunities due to liquidity shifts and risk-aversion. This opens up excellent opportunities for lower-risk relative-value strategies, which allows the fund to earn absolute returns even when markets are doing poorly. Another attractive area that hedge funds can capitalise on is the derivatives markets, as higher market volatility increases implied volatility in the options markets and thus provides for attractive opportunities to earn absolute returns by carefully selling volatility at good prices and then buying cheaper optionality to achieve capital protection on the total portfolio. 

These alternative strategies also exhibit lower correlations to risk assets like equities and bonds. Therefore, a good blend of these alternative strategies can add a return source to the hedge fund while reducing the overall correlation to the market, which we believe is a key ingredient to a good quality hedge fund. This also benefits clients who typically invest in hedge funds by diversifying away the equity and bond risks that they are exposed to in their core investment strategies. 

Higher market volatility and higher equity-bond correlations will challenge long-only strategies in generating absolute returns. Hedge funds have a much wider toolkit of available strategies that can allow them to generate returns irrespective of market direction. That means nimble hedge funds can take advantage of these strategies in order to both protect capital during market drawdowns, as well as earn positive absolute returns, which will be crucial in the current environment. Copyright. HedgeNews Africa – October 2022.

Rayhaan Joosub is co-founder, deputy CEO and portfolio manager of Sentio Capital Management, with industry experience spanning more than 20 years. At Sentio, he has oversight over all investment decisions in the equity, multi-asset and hedge funds. Ray holds a BSc in Chemical Engineering as well as a BCom. Prior to founding Sentio in 2007, Ray was head of Alternative Investments and Quants at RMB Asset Management where he oversaw a team that managed in excess of R25 billion, in collaboration with other traditional areas at the asset manager.