This news service talks to Sussex Partners, a UK-based business that advises institutions about hedge fund allocations. With markets often volatile at times, and recovering after the selloffs of 2022, what approaches appear to work best?

The rise in interest rates means that bonds once again give investors options and are in less of a hurry to deploy cash, opening opportunities in segments of the market, a figure in the hedge fund space says.

“We avoided equities last year and came into this year positioned underweight equities. We are increasing short-term fixed income [holdings] and equity allocations,” Patrick Ghali, co-founder of Sussex Partners, a UK-headquartered business focused on providing institutional investors advice on their hedge fund allocations, told this publication in a call.

Risks of a probable recession around the world and the weakening state of the Chinese economy are factors weighing on minds, Ghali continued. 

Stocks and bonds were hit last year as rates rose, raising the question of whether holders of these assets did not move quickly enough to reallocate, or were holding fast to capture an eventual rebound. “Are these managers suffering because they hadn’t seen the market turning or just early into the move?” he asked, rhetorically.

Across all strategies around the world, hedge funds haven't got investors uncorking the champagne, although some individual strategies have fared reasonably well. The HFRX Global Hedge Fund Index, produced by Chicago-headquartered Hedge Fund Research, is up 1.38 per cent since the start of this year (as of September); the HFRX Equity Hedge Index shows a result of 3.18 per cent.

Sussex Partners was founded in 2003. Ghali is no stranger to giving his views about investments, financial markets and the place that hedge funds should take in HNW individuals’ portfolios. (See a guest commentary from him here.)

There’s been a lot for hedge fund firms to deal with in recent years, such as markets turning choppier amid worsening geopolitics, rising rates, Russia/Ukraine, and deteriorating relations between the West and China. 

Even so, the media coverage can sometimes imply that markets are far more volatile than they were a few years ago, although over five years to date, the VIX Index of US equity volatility, for example, is around 16, up from 11.7 five years ago and way down from the 30-plus level for most of the subsequent period, and far down from the early 2020 spike when the pandemic went global. 

What’s Ghali’s take on volatility? 
While volatility can be played as a strategy in its own via options markets, for example, Ghali said he is wary: “Unless you time this perfectly then you don’t make money.”

Macro strategies – which seek to profit from directional moves in stocks, bonds, forex and interest rates and linked to government/central bank policy, have performed better in recent years than during the decade after 2008 when very low interest rates pumped up asset values, he continued.

“We like macro and sometimes blend it with different perspectives [of managers] from around the world,” he said, noting that a macro hedge fund manager in Asia will have a different angle on the world from one in, say, the US.

Areas to watch
Ghali said he likes strategies such as convertible arbitrage strategies, because a number of issuers face refinancing. (With convertible arbitrage, a fund will short-sell the equity option of a convertible bond, take a long position on the debt portion, and aim to profit on movements in the prices of both.) In credit markets more broadly, yield spreads (between bonds and government debt) are comparatively tight, which means holders of credit aren’t getting much compensation for the risks, Ghali continued. 

China?
The Asian giant has been beaten up by investors in recent months, alarmed about deteriorating real estate markets and associated debt, cracks in the financial system, and a sense that Beijing’s Communist Party leadership is putting ideology ahead of market efficiency. 

With Chinese markets on the back foot, there must be opportunities to exploit, Ghali said. “I haven’t seen anything like it for 20 years,” he continued. 

“We can trade it and should be able to take advantage of volatility – maybe that seems somewhat contrarian,” he said. 

Ghali agrees that Japan’s financial story has improved, on the back of corporate governance reforms that unlock value from cash-rich balance sheets. In general, however, Japan should be interesting because it is a great  “Alpha” story rather than just one of more general growth. “There’s a lot of `tourist’ [foreign investor] money coming in. The risk is that some of these inflows may reverse,” he said. 

The Alpha opportunities in Japan stem from how only a small number of firms have any analyst coverage, opening opportunities for managers who can conduct primary research. Additionally, only a very small part of the market capitalisation of the Japanese stock market is represented by hedge funds, in contrast to the US or Europe, he added.