(Bloomberg) -- Hedge funds on the heels of a surprisingly strong performance in 2017 are raising hopes for an encore.
Investors expect their managers to return 8.5 percent in 2018, according to a Credit Suisse Group AG survey. That’s the most enthusiasm around the smart money since 2012, when global markets were rallying in recovery mode, benefiting from a massive injection of monetary stimulus.
While real-money managers have attempted to curb expectations in a world of normalizing rates and increased volatility, hedge fund outlooks have brightened after surprising on the upside last year. The average realized return was 8.5 percent in 2017, versus an allocator target of 7.3 percent, according to the survey conducted in December and January, covering 45 participants with $1.1 trillion in hedge funds.
It may be more than just a case of recency bias, however. Whipsaw trading and market-moving headlines have put hedge funds in their comfort zone, where they can suss out inefficiencies and prove their security-selection mettle. It’s an advantage that’s been rare in a relentless fixed-income and equity bull market pushing index-trackers higher and higher.
“There’s a lot more dispersion and volatility which should be beneficial if managed properly,” Benjamin Dunn, president of the portfolio consulting practice at Alpha Theory, which works with money-management firms, said. “It allows these guys to capture a lot more alpha than in the past few years where we had volatility suppression.”
To some degree, the survey results represent a return to normal for hedge funds who in recent years saw investor confidence collapse under less favorable conditions. The target return this year is still down from 11.3 percent in 2010 and 10.6 percent in 2011.
“Hedge funds had a strong year of performance in 2017, so it’s only natural that investors would have increased expectations going into 2018,” said Robert Leonard, managing director and global head of capital services at Credit Suisse. “Investors are also increasingly looking to their hedge fund portfolios for downside protection as market valuations have steadily risen over the past few years.”
Even so, asset managers face plenty of headwinds in 2018. Correlation between asset classes has been on the rise, leaving managers without natural hedges and reliable diversification. Sharply reversing momentum has also created trouble for trend-following hedge funds, which experienced the worst monthly drop since 2001.
For passive investors with strategic allocations, lofty valuations have created low expected returns of 3-to-5 percent per year, according to Vanguard projections for European-based investors over the next decade. Hedge funds are unlikely to beat those numbers -- regardless of market environment, active managers lag behind their passive benchmarks, in large part due to higher fees, said Alexis Gray, senior economic on Vanguard’s investment strategy team.
“Every hedge fund is going to say, ‘Now is the moment where I’m about to outperform,” Gray said. “But if you look back at the record, that tends not to be true. Some may generate alpha, but then they tend to charge more for that alpha.”
Still, managers have given allocators reason for optimism so far this year. Hedge funds on Credit Suisse’s prime services platform have returned 1.1 percent, led by emerging market and global macro funds which posted gains as high as 2.9 percent through February. Meanwhile, equity long-short managers saw both bearish and bullish bets hold up amid the recent turbulence, according to Mark Connors, the head of risk advisory at the Swiss bank.
“Hedge funds have generally weathered the storm very well,” said Dunn. “If hedge funds can’t perform in this type of environment, than as an industry we’re losing the battle for our existence.”
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