In Brief
- Our historical data suggest that, on average, hedge fund excess returns (total returns minus equity beta) have risen in tandem with interest rates for 28 years, since the inception of our data set.
- To isolate the impact of this single variable—short-term interest rates—on returns, we remove the impact of equity market returns from our data history.
- What explains this observably strong relationship between hedge fund excess returns and higher rates?
- Hedge funds benefit directly from the increase in short-term rates due to cash balances and short-interest rebates, and through holding floating-rate securities.
- Also, higher interest rate environments are often associated with heightened volatility that in turn creates greater alpha opportunities.
How do higher rates impact hedge fund excess returns? The question is on the minds of many of our clients. The quick answer: On average, our hedge fund excess returns (removing the impact of equity markets) and interest rates have risen in tandem going back to April 1995, when our data set for our hedge fund complex begins (Exhibit 1). But a longer explanation of the methodology is necessary. We’ll define the chart’s terms and then look at the moving parts driving the answer.
Calculating hedge fund rolling 12-month excess returns minus equity beta
Over the 28-year track record of our hedge fund complex, short-term interest rates ranged from a low of zero to a high of 6%. While we allocate across a mix of strategies, with a strong emphasis on uncorrelated and alpha-driven investments, we have a moderate allocation to strategies that carry equity beta. Measuring the impact of higher short-term rates alone requires removing the impact of equity beta from our return history.
To do so, we calculated the trailing equity beta of our return distribution and multiplied that number by the observed MSCI World Index monthly performance; then we subtracted that from each monthly return. The exercise broadly removes the impact of equity beta from our return history while retaining the impact of our managers’ alpha.
This graph suggests that there is a material positive relationship between excess hedge fund returns, on average, and higher short-term rates.
What explains the relationship we have plotted? Two principal components drive this conclusion.
1. Short-term rates have a direct – or “mechanical” – impact on hedge fund performance.
There are several ways this occurs. In one instance, many managers hold excess (unencumbered) cash that is not required as collateral to support their positions. Such monies are traditionally invested in short-term cash, and as yields rise, those hedge funds’ returns benefit mechanically.
Another example: The short-interest rebate. In these cases, as interest rates rise and a hedge fund has been a short seller of securities, the fund will benefit from an increased payment from the lender.
Finally, hedge fund managers may invest in certain securities with floating-rate characteristics, which, all else equal, will benefit from rising rates.
The magnitude of this direct impact differs across hedge funds and hedge fund strategies, based on their margin requirements, leverage profile, approach to shorting, fees, etc. However, on average, we estimate that hedge fund industry returns will benefit from approximately 60% of the increase in short-term rates (depending on the strategy composition, manager fees and other industry characteristics).
2. The rise in short rates can potentially improve certain strategies’ opportunity set.
The second, and often more significant, way that higher short-term rates impact hedge fund performance is by creating opportunities. Broadly speaking, higher interest rates drive a rise in volatility, and higher vol is related to greater alpha opportunities. (In contrast, lower short-term rates are often associated with more robust beta opportunities and, in many cases, a reduced opportunity to add significant alpha.)
One example of why this happens: In a heightened volatility regime, stock price dispersion tends to be elevated, which provides a robust opportunity set for skilled stock pickers to benefit from both long and short positioning. In a similar vein, fear and forced trading can become more prominent in high volatility markets. This allows managers of short-term statistical arbitrage strategy funds to trade, and potentially profit from, more mean-reversion opportunities.
But our most important conclusion is this: The larger the distance grows between the black regression line and the x-axis, the greater the excess returns due to changes in the opportunity set.
Hedge Funds
Investments in hedge funds involve a high degree of risk and are only appropriate for investors who fully understand and are willing to assume the risks involved. Hedge funds often engage in leveraging speculative investment practices that may increase the risk of investment loss. The regulatory environment for hedge funds is evolving and changes therein may adversely affect the ability of hedge funds to obtain leverage they might otherwise obtain or to pursue their investment strategies.
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FAQs
In Brief. Our historical data suggest that, on average, hedge fund excess returns (total returns minus equity beta) have risen in tandem with interest rates for 28 years, since the inception of our data set.
How do interest rates affect hedge funds? ›
Rising interest rates directly impact a variety of hedge fund spread-based arbitrage trading strategies. When interest rates increase, arbitrage spreads widen, thus increasing an investor's expected return.
What are the average returns for hedge funds over time? ›
All hedge funds tracked by BNP Paribas returned an average of 7.66% in 2023, differing from the survey results released on Feb. 12. In 2022, these hedge funds returned an average of 0.42%, said a BNP spokesperson. However, survey respondents said their hedge fund portfolios returned an average of 1.1% in 2022.
What is the 2 20 rule? ›
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
How do hedge funds get such high returns? ›
Many hedge funds utilize leverage as part of their strategy to enhance potential returns. This is typically done using derivatives, which often carry low-margin requirements (a portion of notional value in cash or equity required as collateral to borrow from the broker).
Do hedge funds have high returns? ›
Higher returns are hardly guaranteed. Most hedge funds invest in the same securities available to mutual funds and individual investors. You can therefore only reasonably expect higher returns if you select a superior manager or pick a timely strategy.
Do hedge funds offer higher returns? ›
Hedge funds have the same basic pooled fund structure as mutual funds. However, hedge funds are only offered privately. Typically, they are known for taking higher-risk positions with the goal of higher returns for the investor. As such, they may use options, leverage, short-selling, and other alternative strategies.
What is the 2 20 rule for hedge funds? ›
"Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark.
What is the most successful hedge fund return? ›
Citadel, which ranked second in 2023, made $8.1 billion in profits after bringing in a record-breaking $16 billion in 2022. Its $74 billion in gains since inception rank it as the most successful hedge fund in history.
What is considered a good return for a hedge fund? ›
Most hedge and private equity funds target a net IRR of 15% for their investors (after fees). This provides their investors with a meaningful premium over historical average stock market returns of 8%.
A "2 and 20" annual fee structure—a management fee of 2% of the fund's net asset value and a performance fee of 20% of the fund's profits—is a standard practice among hedge funds.
What are typical hedge fund fees? ›
The asset management fee is generally between 1% and 2% of the fund's net assets, and is typically charged on a monthly or quarterly basis. The performance fee, structured as an allocation of partnership profits for tax purposes, has historically been 15 – 20% of each investor's net profits for each calendar year.
How are hedge fund managers paid? ›
The 2 and 20 compensation structure means that the hedge fund's operating agreement calls for the fund manager to receive 2% of assets and 20% of profits each year. It's the 2% that gets the criticism, and it's not difficult to see why. Even if the hedge fund manager loses money, he still gets 2% of assets.
Why are hedge fund owners so rich? ›
Hedge funds seem to rake in billions of dollars a year for their professional investment acumen and portfolio management across a range of strategies. Hedge funds make money as part of a fee structure paid by fund investors based on assets under management (AUM).
Why do so many hedge funds fail? ›
Some strategies, such as managed futures and short-only funds, typically have higher probabilities of failure given the risky nature of their business operations. High leverage is another factor that can lead to hedge fund failure when the market moves in an unfavorable direction.
Do hedge funds make money during recession? ›
Do Hedge Funds Make Money in a Recession? Hedge funds often outperform the market during recessions. Different types of hedge funds do better than others in a recession—for example, dedicated short bias funds are designed to make money during down markets by shorting various financial instruments.
Do hedge funds deal with interest? ›
Hedge funds benefit directly from the increase in short-term rates due to cash balances and short-interest rebates, and through holding floating-rate securities. Also, higher interest rate environments are often associated with heightened volatility that in turn creates greater alpha opportunities.
What is an interest rate hedge fund? ›
An Interest Rate Hedge, or Swap, is a financial solution that allows qualified loan customers to swap a variable interest rate for a fixed rate over a defined period of time, increasing the predictability of cash flow. In addition, more complex structures such as forward starting swaps, caps and collars, etc.
Do hedge funds use carried interest? ›
Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds. Carried interest is due to general partners based on their role rather than an initial investment in the fund.
Do hedge funds get carried interest? ›
Carried interest is a share of the profits of an investment paid to the investment manager in excess of the amount that the manager contributes to the partnership, specifically in alternative investments, e.g., private equity and hedge funds. It is a performance fee rewarding the manager for enhancing performance.
