UBS explains three hedge fund strategies in a high-rate environment

The case for hedge funds is shifting as interest rates rise.

Brent crude remains near $107 a barrel due to a Middle East stalemate, keeping global government bond yields on the rise. UBS notes that central banks have indicated rates will probably stay high in the near term because inflation is persistent and growth is sturdy. According to a recent UBS note, such conditions have historically been favorable for hedge funds, and the bank sees a case for allocating to certain strategies.

UBS offers several observations.

According to UBS, hedge funds have delivered positive cumulative returns during every Federal Reserve tightening cycle since 1994 and have typically outperformed global bonds. In the most recent cycle, global bonds dropped roughly 12%, while hedge funds ended with positive returns. UBS cautions that higher rates are not a guarantee of strong hedge fund performance. The bank's reasoning is that when capital is more expensive, company fundamentals, policy divergences, and relative valuations become more important, providing more opportunities for skilled managers.

UBS outlines three strategies.

• Equity market neutral: Managers in this strategy buy certain stocks while shorting others, effectively neutralizing broad market moves so that stock selection drives returns. UBS states that this approach is currently aided by financing costs that favor companies with strong balance sheets over weaker ones. The average S&P 500 stock has implied volatility roughly 2.5 times that of the index, compared with a more typical 1.8 times. Meanwhile, the average correlation between stocks stands at about 0.08, versus a median of 0.23 since 2002. In simpler terms, individual stocks are moving more based on their own news and less in tandem.
• Discretionary macro: Managers in this category rely on judgment to take positions across countries, currencies, commodities, and interest rates, without requiring a single directional view on rates. UBS notes that central banks responding differently to local conditions broadens the range of possible outcomes and weakens the connections between markets.
• Fixed income relative value: This strategy aims to profit from pricing discrepancies between related bonds, rather than betting on which way yields will move. UBS points out that the US 2-year Treasury yield has increased by roughly 130 basis points over the past year, compared with about 110 for the 10-year and about 85 for the 30-year. This alters the yield curve's shape and generates mismatches that can be traded.

UBS also identifies a place for multi-strategy funds, which can move capital between these opportunities as conditions evolve.

Risks and caveats to consider.

This represents one bank's perspective, and UBS rates fixed income as Attractive, so it is advocating for an allocation. Hedge funds also entail costs and constraints that UBS enumerates: leverage, limited transparency, volatility, higher fees, illiquidity, and longer lock-up periods. The bank notes that historically high leverage in relative value makes manager selection particularly critical. Most individual investors cannot directly access these strategies, so the note is best seen as an explanation of how they function.

Factors that could change the picture.

The thesis depends on rates remaining high and policy remaining divergent. Faster rate reductions, a resolution to the oil stalemate, or central banks again moving in tandem would particularly undermine the case for macro and relative value strategies. If stock correlation returns to its long-term average, the advantage UBS sees for market neutral managers would diminish.