United States

Hedge funds will be tested as U.S. fundamentals remain frail

Managers must pursue returns by hedging against volatility

INSIGHT ARTICLE  | 

Middle market hedge fund managers are coping with a contradiction—as the world unravels due to COVID-19, the S&P 500 is nearing an all-time high. While the markets respond favorably to progress on a vaccine, money managers are looking to a future with a high degree of uncertainty around a possible U.S. recovery amid weak fundamentals.

Some background: On March 11, the World Health Organization declared the novel coronavirus a global pandemic and two days later a national emergency was declared in the United States. The S&P, after hovering between 3,000 and 3,100 in early March, nosedived below 2,400 in the days that followed. But since that time it has steadily escalated to near pre-pandemic levels.

Source: Bloomberg

However, if investors gauge the health of the U.S. economy simply by S&P returns, they would be grossly misled: There are massive disconnects between economic fundamentals and the pricing of public markets. What stands in front of a continued rally are sustained job losses, uncertainty over school re-openings, a looming U.S. presidential election, an active hurricane season, the ongoing trade spat with China and the effects of Federal Reserve monetary policy.

In keeping with their alternative approach to investing, middle market hedge funds have generally capitalized on the market volatility that has ensued from the virus and the subsequent rise of the S&P. From May through August, U.S. middle market hedge fund managers—defined as managers with $5 billion or less of assets under management—earned 14.5%, and August results were solid, finishing at 13.1%.

What stands in front of a continued rally are sustained job losses, uncertainty over school re-openings, a looming U.S. presidential election, an active hurricane season, the ongoing trade spat with China and the effects of Federal Reserve monetary policy.

Managers, as they are trained to do, must pursue risk-adjusted returns by hedging against volatility in the market, and that has worked in their favor during the pandemic and should continue to do so if there are major market moves such as those observed in mid-March and April. But with so many companies struggling through supply and demand shocks, workforce changes, and liquidity issues, companies will undoubtedly suffer lost earnings that will affect hedge fund returns, particularly those that hold investments in the real economy.

Strong returns and steady fees seen

Investors have taken notice of middle market returns and, as a result, have increased allocations to hedge funds and other alternative strategies in the second half of 2020. Positive performance for the year has contributed to expectations for strong industry-wide growth into 2021, but many factors are still uncertain. And there is still a lot of capital chasing investments, which also bodes well for middle market hedge fund managers.

At RSM US LLP, we expect hedge fund managers’ fees—always higher than other alternative asset classes—to hold steady, despite investments moving more toward passive and fixed income funds of late. We have observed a steady decline of middle markets fees over the last several years, and what was thought of as ordinary (a 2% management fee and 20% incentive fee rates) has moved lower (closer to 1.4% and 18.9%, respectively). And although middle market managers have forfeited points on their management fees, incentive fees have not been as influenced, and aren’t expected to be, especially since incentive fees are the target of Democratic leaders who aim to tax profits at ordinary rates in the event of a change in the White House. With performance as it has been, managers are justified in holding rates as they are, and some of the big winners may even choose to increase fee rates.

In the months to come, middle market hedge funds must take a measured investing approach and weigh the numerous risks in the U.S. economy. On a short-term basis, market volatilities have the power to vary returns, but those taking a long-term view are expected to be the victors. Managers who target technology and health care businesses have the largest upside, but those targets are accompanied by correspondingly higher risk. Companies embracing environmental, social and governance investing programs remain popular, as are those with first-mover technology advantages or sound digital transformation strategies. Depending on how much longer the United States struggles through its pandemic recovery, global equities may also offer upsides to investors.

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