In this post I provide a framework for developing current return expectations and determining the appeal of a hedge fund allocation. Its underlying risk exposures reflect the combination of four key return drivers:

• short-term interest rates
• embedded market beta, such as equity, credit, rates, currencies, and commodities
• alternative beta, such as style factors and strategy premia
• alpha, or idiosyncratic risk not explained by any of the other three

To assess the appeal of hedge funds, we consider the current environment and outlook for each of these four components based on long-term secular trends as well as short-term cyclical considerations.

INTEREST RATES: To control risk or enhance return, hedge funds use short-selling, derivatives, leverage, or simply holding cash, all of which are powered by short-term interest rates. Therefore, the level of short-term rates directly affects a fund’s expected returns.

Central bankers have made it clear that short-term rates will remain suppressed to some degree for years to come. However, as the global economy picks up steam, central banks are recognizing the need to begin normalizing short-term rates. Soon, holding cash may no longer generate negative real rates of return. Although stock and bond prices may discount yields on cash, they do not directly benefit from climbing short-term rates like hedge funds normally do.

MARKET BETA: Hedge funds pursue returns that are less dependent on normal market activity. However, despite claims of acting independently, most hedge funds still find themselves leaning, directly or indirectly, on capital markets. And although rising and falling markets do not necessarily dictate the success or failure of hedge funds (aside from short-biased ones), they do set the tone of investors’ risk appetites and willingness to explore hedge fund allocations.

In a market environment long supported by central bank-provided liquidity, the return expectations for global equities are modest by historical standards. (Today’s wild card is how long-term interest rates react to central banks “normalizing” their balance sheets.) Mid-single digit returns are likely for public U.S. equity, barring an economic miracle of much greater productivity growth. While valuations on non-U.S. equity in developed markets look attractive, that is relative to a richly valued U.S. market. Supported by rising commodities and a falling dollar, emerging markets have become more compelling investment options, but capacity or investor resolve to allocate materially to these less liquid, less developed markets is limited.

Looking beyond the public equity market, we find other capital markets similarly priced without much margin for error. Long-term Treasury yields are still below 3%. Long-term investment grade spreads over Treasuries are firmly below 1%. Effective yields on U.S. high yield credit are below 5.5%. Real estate capitalization rates for most property types are below 5%, consistent with their usual spreads over 10-year Treasuries and corporate bonds. Private equity offers the allure of higher returns, but significant capital already raised for deployment will likely dilute prospective returns in an already hot market.

Hedge funds will capture a portion of these returns from capital markets, up or down. Given how likely meager those market returns could be, though, their impact will be even more modest than it has been.

ALTERNATIVE BETA: In addition to embedded market exposures, hedge funds often use other systematic risk premia or otherwise scalable strategies that are not directly related to market movements. Since these systematic risk premia or strategies are often uncorrelated with traditional markets and are shown to offer positive returns over long time horizons, they are attractive diversifiers.

Since these alternative betas can be harvested with scalable, rules-based processes, hedge funds now find themselves sharing these market opportunities with competing multi-asset class (MAC) solutions at much lower costs. The investor’s choice of using hedge funds or these lower-cost solutions will be driven by whichever demonstrates better risk-adjusted returns net of all fees.

ALPHA: Given the high-cost structure of hedge funds, they need to be more narrowly focused on idiosyncratic risk and on one-off trades that cannot be easily replicated. If they demonstrate a competitive edge for reaping these harder-to-find pearls unrelated to traditional and alternative betas, investors that believe in their value proposition are willing to compensate them appropriately for their better diversifying returns. With this differentiated focus, such hedge fund allocations can complement a MAC allocation in a more cost-effective manner for investors to harvest both alternative betas and idiosyncratic risk premia. But alpha is hard to find, like pearls in the ocean.

For more on the outlook for hedge funds in 2018, including a look at changing market dynamics that will shape the opportunities for alpha seekers, please see my recent paper, “Outlook for 2018–No Grit, No Pearl.”