After sluggish performance over the past several years, investors in equity hedge funds are certainly hoping for better results in the year ahead. According to Barron’s, over the last three years, equity hedge funds have averaged a return of only 3.42 percent. This is less than half the return investors in fixed income funds experienced, yet equity investors were also faced with higher volatility.
It’s not only investors that are looking forward to a brighter 2013, but fund managers as well. Many equity hedge funds are seeing investors head to the exits and exchange their low performing, high fee assets for those in fixed income or other strategies. In fact, in the first nine months of 2012, investors withdrew a net $9.5 billion from equity hedge funds while placing an additional net $34.9 billion in investment with fixed income hedge fund managers.
Fixed Income Funds May Struggle to Keep Up With Equities in 2013
While investors fled equity funds in 2012, fixed income may be the next asset class to feel some pressure as the last remaining yield is squeezed out of nearly every possible investment class. Over the past several years, investors have seen yields drop in nearly every segment. First were government bonds, then high quality corporate issuers, followed by a decline in mortgage backed securities and even high yield issuers. While the decline in yields and the corresponding increase in fixed income asset prices has been great for investors, this trend will eventually need to reverse or at least slow down. Yields are now at the point where significant returns can only be made through price appreciation, and betting on further large scale shifts in the yield curve certainly carries some risk.
While attractive fixed income yields can still be found in a handful of foreign markets, currency exposure is becoming a concern as well, making these investments far from low risk. While it would be premature to call an end to fixed income hedge fund returns at this point, fund managers will need to be more creative in 2013 to generate attractive returns.
Investors May Be Encouraged Back to Equities By Lower Volatility
On the equity front, investors may begin to be encouraged back towards equity investment not only by higher possible returns, but also through lower volatility. Volatility indexes reached five year lows towards the end of December, even in the face of possible economic trouble surrounding the fiscal cliff. This marks a significant change in underlying tone and outlook towards equity markets in the United States. As investors begin to gain confidence in equities again, this should have positive impacts not only on flows towards equity hedge funds, but also in underlying stock prices.
After a Difficult Year, Some Optimism for the Year Ahead
After what was a difficult year for equity hedge fund managers, some encouraging signs are beginning to create some optimism in the segment once again. While there is certainly significant risk still on the horizon for global equities, improved confidence and lower volatility may encourage some investors back into equity. Declining fixed income returns should only help push investors from bond-focused funds back towards equities. While this would be welcome news for equity hedge funds, the outlook in far from certain and equity fund managers will need to be both creative and opportunistic in order to offer a winning value proposition to their investor clients.