For Hedge Funds, Rising Rates Mean Opportunity

AllianceBernstein contends that the era of rock-bottom interest rates has ended and that elevated rates, combined with inflation the firm expects to remain high for some time, warrant renewed attention to hedge funds and alternative strategies. The firm notes that higher rates have depressed corporate earnings expectations, increased market volatility and prompted investors to adjust allocations, with public market options including more selective equity exposure and a tilt toward bonds to capture higher yields.

The firm argues that long/short equity strategies, which struggled after the global financial crisis when near-zero rates drove nearly all stocks higher, are better positioned now. Volatility has risen sharply over the past 18 months, increasing dispersion of equity returns. In three historical periods when rates held between 5% and 6% for at least six months, average three-month implied volatility on the S&P 500 exceeded the 1979-2023 average and average three-month stock correlations were lower. AllianceBernstein expects these conditions to persist with rates likely to remain high in 2024 and possibly beyond. The firm observes that cash-rich companies with robust free cash flow may pursue acquisitions or strategic investments while servicing debt, whereas firms with weak cash generation or maturing debt face higher refinancing costs. Given how widely long/short is used, the firm stresses manager selection, and suggests multi-portfolio manager strategies may offer return diversification and downside risk management. Unencumbered cash balances can also contribute returns given elevated cash rates.

In merger arbitrage, the firm states that rising rates can widen the spreads investors demand, raising return potential. It acknowledges that higher rates have slowed merger activity this year, but argues that companies with strong free cash flow may gain market share with less competition, provided acquisitions do not require costly new debt. The firm says merger arbitrage returns have shown low correlation to long-term market direction, since the spread compensates investors for deal-failure risk. It flags sharper US and UK regulatory scrutiny of deals and recommends investors assess managers' track records, experience and due diligence processes. Some managers invest only in deals with the highest probability of closing, while others size positions by risk.

For systematic macro, AllianceBernstein describes the strategy as a heterogeneous category making directional and relative value trades across asset classes and geographies using derivatives on equity indices, bonds, currencies, commodities and sectors. Signals such as carry, trend and value react differently to higher rates: carry benefits directly from rate dispersion, while value may suffer. Diversification across signal categories, the firm says, helps keep portfolios uncorrelated to specific regimes. Because derivatives require less physical capital, managers typically hold excess cash that can earn high short-term rates. The firm concludes that a diversified portfolio is robust across market conditions, and that hedge fund strategies can complement traditional equity and bond allocations, particularly during periods of changing conditions.