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Gennadiy Friedman
Managing Director
Enfusion
Hedge funds entered 2023 amid rough waters. Macroeconomic and geopolitical concerns have created greater uncertainty. In parallel, the relentless tide of new regulatory requirements creates increased operational complexity. These factors represent an unprecedented wave of change.
Multiple factors affected 2022 hedge fund performance, from high inflation and rising interest rates to the war in Ukraine and pressure on the global energy supply. While overall hedge fund returns declined by 2.4% in 2022, four strategies outperformed and achieved positive returns. At the top were multi-strategy and quant funds, up 9.5% and 8.5%, respectively. Macro and arbitrage funds also were positive, at 6.7% and 3.6%.1
This convergence of economic and geopolitical trends will likely continue impacting the relative performance of hedge fund strategies in 2023. In turn, greater market uncertainty and added operational complexities require funds to evolve their approach to managing risk.
As a result, they need the right tools to support this shift. Funds are increasingly demanding solutions that allow them to fine-tune their models and analytics with accuracy, clarity, and simplicity.
The End of Cheap Money
Investors and investment managers knew that low interest rates would not last forever and that COVID quantitative easing programs would eventually taper off. As these conditions changed, factors such as inverted yield curves and credit spread volatility brought new challenges—hence the positive data for arbitrage funds, which often thrive on volatility.
With few assets emerging unscathed from 2022, funds face new pressures to operate efficiently and remain competitive. They are under pressure to prioritize performance and profits while keeping pace with transparency, due diligence, and risk analytics. Moreover, tighter monetary policies and market volatility create dislocation that may benefit certain strategies, such as distressed credit, exotic FX, derivatives, and swaps.
Turbulence at Many Levels
From a risk perspective, funds focus on multiple Value-at-Risk (VaR) approaches, including parametric and historical VaR, Monte Carlo simulations, and various stress tests. Through Enfusion’s work with clients and partners, we see first-hand that capabilities that enable more complex risk modeling and analysis are at a premium when uncertainty and volatility are high.
We also see shifts in the ways firms are executing their strategies. For example, distressed credit funds are pursuing fundamental trading, tapping into bonds and equities more often, or using arbitrage strategies to take advantage of price discrepancies in the market. Moreover, we have seen our clients turn towards products with a complex P&L profile, such as triple digital FX options, dual digital kick-in/kick-out, and digital constant maturity swap (CMS) spread. By contrast, we are hearing from other funds not using Enfusion that they struggle with the constraints of a Portfolio Management System that lacks multi-asset flexibility.
The Long Tail of the Global Financial Crisis
Finally, hedge funds must still address the significant regulatory and risk management changes made after 2008. Heightened requirements for due diligence and transparency continue to affect the operational realities of hedge funds.
For example, the introduction of uncleared margin rules (UMR) increased the focus on collateral management practices. In addition, initial margin is highly dependent on value-at-risk (VaR) stress tests. As a result, funds need the ability to use margin optimization in the trading decision-making process. Liquidity management, through daily monitoring of the unincumbered cash, has also become important so that managers can know how much is available at any point in time. Portfolio managers and traders who have this data easily accessible, accurate, and in real-time are at a significant advantage.
Conclusion: Scaling to Thrive
Meeting investor demand for risk-adjusted returns on capital with a high Sharpe ratio requires more transparency in investment portfolio strategies. Moreover, investors look for operational precision and control when conducting due diligence. It comes down to internal risk policies and procedures supported by the right tools. In addition, investors favor decoupling trading and risk functions within an organization. Doing so is more coherent when functions use the same source of truth, consistently updated in real-time throughout the trading day.
The new regime is characterized by tighter financial conditions, less liquidity, high volatility, and generally higher risk premiums. At the same time, flourishing in it requires an investment management system that can easily scale to meet fast-moving harsh market conditions and increasingly stringent investors. Embracing such a system may be the difference between striving and thriving.
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