Hedge funds have a strong historical record of outperformance when it comes to navigating the volatility of high interest and high inflation rate environments, but as a long-awaited Federal Reserve monetary policy switch looms, are institutions sufficiently prepared to navigate interest rate cuts?
Recent weeks have seen hedge funds make more cautious moves on Wall Street, despite more strategists raising their targets for the S&P 500 Index.
Decreasing their long-short gross leverage, Goldman Sachs data shows that many hedge funds spent June 2024 actively lowering their exposure to the market at their highest collective rates since March 2022.
This slowdown indicates that institutional investors are becoming less certain about plotting moves in the current market environment.
Despite early expectations of the Fed cutting interest rates as quickly as March in 2024, which failed to materialize amid hotter-than-expected Consumer Price Index data, forecasts point to September as the month when cuts begin to take place.
Consistent delays to rate cuts and the promise of monetary policy reversion have created more volatile markets that traditionally play into the hands of resourceful hedge funds, so what’s different now?
High Rates Mean High Institutional Performance
We can look to the past to assess how lower rates typically impact hedge funds. In the wake of the 2008 financial crisis, the switch to a dovish monetary policy made it more challenging for hedge funds to generate alpha as near-zero interest rates impacted the discovery of new asset prices.
Using the Albourne Hedge Fund Index as a benchmark, hedge fund alpha generation dropped to its lowest levels as the Fed introduced historically low interest rates between the financial crisis and the COVID-19 pandemic, briefly dipping below 0% in 2019.
With hedge fund performance operating on a strong positive correlation between high interest and high inflation, recent years have offered plenty of opportunities for institutional investors to make exceptional profits.
This outperformance has spilled into 2024, with repetitive delays to long-awaited interest rate cuts so far failing to materialize.
However, with a switch to a dovish monetary policy now getting closer, we’ve seen that hedge funds have adopted a more cautious outlook for the market. Could this mean that the headwinds that made it so hard to generate alpha over the past decade could return for institutions?
It could mean that it’s time for hedge funds to get more street-wise in identifying investment opportunities on Wall Street.
Embracing the AI Revolution
Generative AI is set to become a $1.3 trillion market by 2032, and this could play into the hands of hedge funds for a variety of reasons. Most significantly, the technology could help drive big data insights at a time when opportunities become more scarce.
According to an AIMA survey, as many as 86% of hedge funds have provided their staff with access to generative AI tools, making the upcoming Federal Reserve rate cuts a major test for the proficiency of the technology.
Crucially, generative AI can offer next-generation predictive models that analyze extensive datasets to craft actionable insights for hedge funds to act on.
The sheer volume of data that artificial intelligence can curate ranges from historical prices, trading volumes, economic indicators, and a hefty level of unstructured data to inform market decisions.
At its best, generative AI and the machine learning technology that it’s built on can tap into unstructured data on an unprecedented level to provide the level of market intelligence that was impossible to access during the last dovish monetary reversion.
The Age of Alternative Data
Notably, generative AI is capable of using natural language processing (NLP) to conduct contextual social listening to interpret the conversations being had online surrounding different stocks, industries, and commodities to gauge sentiment.
It can even democratize alternative data sources to gain masses of insights stemming from satellite imagery of retail parking lots, credit card transactions, website traffic, mobile app usage, and plenty of other sources to gain an advantage in seeking alpha.
These can form more advanced trading strategies at a time when other hedge funds remain cautious, opening the door for stronger outperformance.
We’re already seeing use cases emerge for hedge funds using machine learning technology to shape insights, with Man AHL and Two Sigma utilizing ML to look for patterns in satellite images that could suggest changes in economic activity.
To act on generative AI and ML insights, it’s worth analyzing prime services for hedge funds that can offer direct market access (DMA) and around-the-clock global coverage to help broaden the volume of opportunity that can be captured.
Preparing for Low Rates
Lower interest rates and calmer waters have long been a challenge for hedge funds, and the underperformance of the 2010s will remain fresh in the memory of US institutions.
However, the technological landscape surrounding investing has changed significantly since the post-2008 downturn, and now insights can be drawn from far more unstructured data sources than ever before.
This will benefit more ambitious and resourceful hedge funds that are intent on out-innovating the calmer market conditions on the horizon.
With this in mind, the arrival of generative AI could be timely for the industry. With the ability to tune into sentiment analysis and satellite imagery to gather economic data first-hand, we could be looking at the early stages of a revolutionary new trend in finance.