Why Goldman Sachs sees uptick in interest in hedge funds in new market regime

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Markets may stay bumpy with interest rates at elevated levels, an environment that Goldman Sachs Group’s Jack Springate says has sparked heightened investor interest in hedge funds.

Investors are facing a new regime where markets may move in a “less consistent and more complex” way compared to the decade before the Federal Reserve hiked interest rates to battle inflation, said Springate, co-head of the hedge-fund business within the external investing group at Goldman Sachs Asset Management, in a phone interview. “It hasn’t been as smooth a ride” for the S&P 500 index in the wake of those rate increases, begun in early 2022, he said.

The widely-followed U.S. stock-market gauge last year plunged 19.4%, its worst performance since 2008 when markets were reeling during the 2008 global financial crisis, FactSet data show. The Fed had then cut interest rates to zero to help the economy recover, but today, investors are navigating markets with the central bank’s benchmark rate at a 22-year high of 5.25% to 5.5%. 

Interest rates remaining higher for longer as the Fed fights inflation would lead to increased market volatility and greater dispersion in stocks—or a wider gap between the winners and losers— providing a good trading ground for nimble hedge fund managers, according to Springate. 

“Hedge funds were generally more defensively positioned coming into this year,” a stance that “worked very well” in 2022, he said. “Regimes when interest rates have been higher and market levels of volatility have been elevated, you’ve generally seen better returns from hedge funds.”

The S&P 500 tumbled last year as the Fed in early 2022 set out on an aggressive campaign of raising rates in a bid to tame high inflation that had surged during the COVID-19 pandemic.

The HFRI Fund Weighted Composite Index, a measure of hedge fund performance globally, was down 4.1% last year, according to an HFR report earlier this month. Although hedge funds fell in 2022, the index widely outperformed the S&P 500 as well as the broad U.S. bond market. 

But this year U.S. stock benchmarks have bounced back, with the S&P 500 ending Tuesday 6.2% below its record close in early January 2022, according to Dow Jones Market Data. The index has soared 17.1% this year even with its August pullback as yields on U.S. Treasury bonds surged. 

The Vanguard Total Bond Market ETF
which provides broad exposure to U.S. investment-grade fixed-income securities, has posted a 1.5% total return this year through Tuesday, after slumping this month as Treasury yields jumped, FactSet data show.  

Last year the bond ETF suffered brutal losses as the Fed raised interest rates, falling around 13% on a total return basis in its worst performance on record since its 2007 launch.

‘Hard thing to tame’

Springate said he isn’t seeing hedge funds “chase the rally” in stocks this year with the “pedal to the floor,” as they’re assessing which industries and companies will be able to navigate an environment with a higher cost of capital.

Managers in the hedge fund industry recognize “the Fed has a difficult needle to thread of lowering inflation without causing the economy to go into a steep recession,” said Springate. “So far so good,” he said, but “inflation can be a hard thing to tame and can lead to more volatile markets with big up and down trends.”

Meanwhile, hedge funds broadly have lagged far behind the S&P 500 this year, with the HFRI Fund Weighted Composite Index posting gains of about 5% through July, the HFR report shows. 

Data from Goldman’s prime brokerage group show equity fundamental managers using long-short strategies had the strongest performance among hedge funds over the first seven months of the year, with a gain of 7%. 

By contrast, macro and commodity-trading-advisor managers were the worst performers among the hedge-fund strategies tracked by Goldman over the same period, each down 1.4%. Quant funds were up 3.5% this year through July, while event-driven strategies gained 3.4% and credit managers rose 5.5%, the data from the bank’s prime brokerage group show.

See: U.S. stocks roar back in 2023 to book best seven months to start a year in decades

Market volatility

The bond market has been volatile this year while the U.S. stock market has been calmer, with the S&P 500 surging against the backdrop of a resilient economy.

The CBOE Volatility Index, a measure of fear in the stock market derived from the S&P 500, traded around 14.5 on Tuesday, well below its 200-day moving average of 18.5, FactSet data show. The index
also dipped slightly below its 50-day moving average of 14.8.

Still, higher-for-longer interest rates and volatility in fixed-income should mean more opportunities for hedge funds to produce market-beating returns compared with an environment in which the Fed is accommodating markets with rates “anchored” at very low levels, according to Springate.

Hedge fund outperformance last year left many institutional investors having to actually “trim” exposure to the investment strategy in the short term because it had become a “much bigger” part of their portfolios relative to other assets, he said.

Meanwhile, Goldman analysts wrote in a portfolio strategy research note dated Aug. 21 that “hedge funds rotated toward cyclicals and increased net leverage” during the second quarter. 

Their analysis was based on the holdings of 744 hedge funds with $2.4 trillion of gross equity positions at the start of the third quarter, according to the note.

“These shifts were rewarded as cyclicals led the market higher in early summer but have been headwinds in recent weeks,” the analysts wrote. “Funds added to energy and lifted their position in financials to the highest tilt vs. the Russell 3000 in over a decade, although funds are still underweight the sector.”

Read: Mutual funds struggling with record underweight in megacap tech stocks, says Goldman Sachs

Yields still up in August

U.S. stocks closed higher Tuesday, with S&P 500
Dow Jones Industrial Average
and Nasdaq Composite
rallying as investors digested fresh data showing job openings dropped in July, in a sign the labor market may be cooling even as the unemployment rate remains low.

As investors assessed the jobs data, the yield on the 10-year Treasury note
retreated Tuesday to 4.121%, the lowest rate since Aug. 10 based on 3 p.m. Eastern Time levels, according to Dow Jones Market Data. Still, 10-year yields remained up 16.5 basis points this month and have jumped 29.5 basis points in 2023 through Tuesday. 

Read: ‘ We are buyers of gold on weakness’: Yellow metal appears resilient after surge in real rates, says Morgan Stanley

Investors are digesting a batch of economic on Wednesday morning, including a report on U.S. employment from payroll processor ADP showing fewer private-sector jobs were added in August than expected by economists polled by the Wall Street Journal. Meanwhile, the U.S. economy grew at a 2.1% annual pace in the second quarter, down from an earlier estimated 2.4%, according to revised data released Wednesday by the Bureau of Economic Analysis.

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