UBS Global Wealth Management discusses hedge funds' performance in 2023 and the outlook for 2024, highlighting their role in mitigating risks.

Although hedge funds' fortunes have waxed and waned, they continue to provide, so their advocates say, an important set of tools to spread risks, exploit market dislocations and, where suitable, market-beating sources of return.

They trailed global equities in January and in 2023 as a whole, as investor optimism over artificial intelligence (AI) and the US Federal Reserve’s policy pivot propelled equities, according to UBS Global Wealth Management.

But this is not an indication that hedge funds have failed to fulfil their expected role in portfolios, in UBS’s view. “The asset class overall is never likely to match stock returns during vigorous rallies, such as the one seen since October. The primary goals of adding hedge fund exposure to a portfolio are to inject alternative sources of return and mitigate risks,” UBS said in a note.

“Recent economic uncertainty indicates this remains important. The equity volatility last week following stronger-than-expected US inflation data provided a reminder that the market is likely to be highly sensitive to disappointing news, especially with the S&P 500 trading close to all-time highs,” the firm added.

With a range of economic, geopolitical, and market risks remaining, UBS thinks an appropriate allocation to hedge funds should help offset potential equity declines and offer agility to navigate the evolving macro regime.

This is provided that investors are aware of certain potential drawbacks of investing in hedge funds, including illiquidity, the firm said.

“Select hedge fund strategies can both capture market gains and reduce market falls. With equities near all-time highs, many investors are asking themselves where to allocate excess liquidity and whether to rebalance portfolios after recent equity market gains,” UBS continued. Historically, due to their focus on risk management and downside mitigation, hedge funds have offered a natural portfolio complement to both equity and credit, capturing upside, adding differentiated returns, and providing some protection against unexpected sell-offs.

Hedge funds can increase portfolio stability and diversification. “While inflation has continued to fall, the risk of stocks and bonds moving in tandem remains if it proves stickier than expected. This speaks in favour of adding a strategic allocation to hedge funds as an additional source of diversification in portfolios,” UBS said.

Elevated interest rates can also support return potential for hedge funds. UBS believes that the Fed has clearly signalled its intention to cut rates this year. But the level of interest rates should remain relatively high, even after the 100 basis points of cuts assumed in the firm’s base case for 2024 overall.

The path towards rate cuts is also likely to contribute to volatility, with the potential to widen the gap between winners and losers. This increased dispersion across securities, sectors, and countries creates opportunities for hedge funds to generate alpha and potentially achieve higher returns.

“We continue to recommend allocating to hedge funds in a multi-asset portfolio. We currently favour low net equity long-short strategies for their potential to exploit stock pricing inefficiencies, credit long-short funds to profit from discrepancies in credit markets, and macro and multi-strategy funds for diversification purposes, as the latter stand to benefit from evolving economic and market dynamics,” Mark Haefele, chief investment officer at UBS Global Wealth Management, said.