Hedge Funds Are Well-Positioned to Navigate Market Swings, According to UBS

Hedge funds have demonstrated their effectiveness in shielding portfolios from significant market volatility, as observed in August 2024. Analysts from UBS noted that hedge funds, particularly those employing non-directional strategies, navigated market disruptions skillfully while mitigating losses in stocks and bonds.

With ongoing market uncertainty, hedge funds are increasingly critical for risk management, improving returns, and addressing unpredictable economic circumstances. Contrary to expectations of a tranquil summer, August 2024 brought notable market turbulence. A mix of low liquidity, poor U.S. economic indicators, and geopolitical tensions contributed to increased volatility.

The volatility index soared, resulting in sharp sell-offs in global equities. For instance, a typical U.S. 60/40 portfolio dropped by 3.1% in just three days. The Nikkei 225 in Japan also experienced a dramatic 20% decline, highlighting the fragility of global markets.

According to UBS analysts, early August’s jittery markets were fueled by thin liquidity amid disappointing U.S. jobs and manufacturing data, raising fears of a “hard landing.” The unwinding of leveraged positions, particularly in Japanese markets, further intensified the situation, leading to considerable sell-offs across all asset classes.

While conventional long-only portfolios struggled due to increased correlations between equities and bonds, hedge funds thrived by delivering uncorrelated returns and seizing opportunities arising from volatility. UBS pointed out that hedge funds with reduced market exposure, including equity market-neutral and alternative credit strategies, outperformed significantly during August’s market fluctuations.

Convertible arbitrage strategies, which benefit from a long volatility profile, gained 1.1% in August by taking advantage of sharp shifts in market sentiment. Additionally, fixed income relative value strategies and credit hedges performed well, with many managers successfully monetizing gains from expanded spreads before markets rebounded.

Hedge funds not only provide downside protection but also excel in environments marked by market dislocations. UBS analysts emphasized that during volatile periods, prices often deviate significantly from their true values, creating unique alpha opportunities for hedge fund managers. By adopting contrarian positions—acquiring undervalued assets or shorting overvalued securities—hedge funds can profit as prices return to their natural averages once markets stabilize.

The success of discretionary macro strategies was highlighted as they adeptly navigated the turbulence in August by capitalizing on global currency and bond market movements. One of the key benefits of hedge funds is their capacity to deliver uncorrelated returns during market instability. As correlations among asset classes rise during stressful periods, traditional portfolios comprising stocks and bonds become more susceptible to simultaneous declines.

Conversely, hedge funds are structured to exploit market inefficiencies and take advantage of price dislocations rather than merely following broader market trends. UBS noted that strategies like global macro, equity market-neutral, and multi-strategy funds are particularly effective at generating uncorrelated returns, aiding in smoothing portfolio performance and mitigating risk. These strategies enable investors to stay involved in high-risk markets while lessening the effects of sharp downturns.

Looking ahead, UBS analysts anticipate continued volatility in the coming months as central banks adjust their monetary policies and geopolitical risks remain elevated. While inflation concerns have eased, economic data continues to fluctuate, casting uncertainty on the future trajectory of Federal Reserve rate cuts. The prospect of the upcoming U.S. presidential election is also expected to bring additional political uncertainty, potentially amplifying market fluctuations.

In light of these factors, UBS recommends that investors consider incorporating hedge fund strategies into their portfolios to better prepare for future volatility. Low net equity strategies, alternative credit, global macro, and multi-strategy funds are viewed as well-suited to help investors manage risks and seize opportunities as markets evolve.

While hedge funds offer significant potential, UBS also highlights the risks involved. Hedge fund investments are often illiquid and may necessitate long-term lock-up periods. Their strategies can also be complex, demanding that investors be ready for potential losses, especially when leverage is involved. Consequently, UBS advises investors to approach hedge fund investments as part of a well-diversified portfolio and to ensure they are comfortable with the associated risks.