The return of volatility is powering more outperformance for hedge funds in Q3 2024

Wall Street has become entrenched in a battle for stability as unexpected labor market data prompted widespread volatility in early August. While the Federal Reserve’s combative monetary policy shifts have come under the spotlight, hedge funds could become a leading beneficiary under the heightened uncertainty. 

The odds of a second major 50-basis point rate cut by the Fed at its November meeting have climbed to 57.4% in recent days, pushing more institutions on red alert for upcoming market volatility. 

Whether the highly dovish policy will lead to a soft landing or recession is the subject of much speculation, but this hasn’t stopped hedge funds from undergoing a prosperous August despite historically high peaks on the Cboe’ Vix volatility index. 

Early August saw the S&P 500 tumble 7% off the back of lower-than-expected labor market data, pushing the Vix 65% higher in its highest jump for more than six years. With an intraday peak of 180%, the index briefly reached a high that hadn’t been seen for at least 20 years. 

With the added uncertainty of the wider geopolitical landscape and the prospect of a close-run US presidential election, more traders are becoming wary over the potential of a more volatile second half to 2024.

As a result, hedge funds are braced for a third and fourth quarter that’s packed with opportunities and risk as Wall Street embraces an unpredictable end to the year. 

Hedge funds thrive on uncertainty

After finding themselves ‘increasingly exposed’ to market turbulence at the beginning of August, many hedge funds successfully navigated the period of high volatility by posting modest gains after the month. 

Backed by the strong performance in equity hedge and fixed income-based relative value arbitrage strategies, the HFRI Fund Weighted Composite Index closed 0.25% higher for August. 

Likewise, the new HFRI Multi-Manager Index rallied 1.6% over the month. This fund focuses on utilizing a multi-manager structure where capital is allocated to independent investment teams that operate under its specified guidelines. 

Healthcare and even technology-focused funds grew in August, closing the month 2.85% and 2.2% higher respectively. 

Despite the impressive performance of hedge funds in August, Mandy Xu, head of derivatives market intelligence at Cboe Global Markets, suggests that there’s a lot of sensitivity among investors in response to the heightened volatility experienced in August. 

Xu notes that the hypothetical arrival of new data detailing a slowing economy could see the widespread volatility experienced on Wall Street become far more concerning for hedge funds. 

Wariness reigns

Although volatility offers unique opportunities for hedge funds, the events of August helped many institutional investors to retrench from their riskier positions to reassess their respective strategies for the second half of the year. 

Major sell-offs throughout global markets have caused the US economy to experience some jitters that haven’t been seen for many years. While this can certainly help hedge funds strategize their growth, it can also expose some positions that don’t have the same strong fundamentals. 

It’s also worth highlighting that the modest gains of hedge funds in August came only after the market rout at the beginning of the month left global macroquantitative funds posting losses of between 1.5% and 2.5% between August 1st and August 5th, 2024. 

Tech-focused hedge funds were even more exposed to the downturn, tumbling between 2.5% and 3.5% at the beginning of the month. 

These figures serve as a timely reminder that a more nuanced approach is required for hedge funds to capitalize on uncertainty, and weaker models could lead to deeper losses amid the volatility. 

Taking opportunities

With market volatility set to continue throughout Q3 2024 and the remainder of the year, hedge funds are uniquely positioned to reap the rewards of asset classes that tend to respond well to market uncertainty. 

The resources available to hedge funds in diversifying portfolios without compromising on returns means that these institutions remain in a strong position to thrive should Wall Street take on a more unpredictable turn. 

HSBC data has shown that the HFRI Fund Weighted Index has outperformed all benchmarks, including the JPMorgan Global Government Bond Index Unhedged USD, and the traditional 60/40 portfolio, over the past 30 years. 

Crucially, the HFRI Fund Weighted Index experienced stronger outperformance in the wake of major events that sparked market volatility like the Dotcom bubble and boom, the 2008 financial crisis, and the COVID-19 pandemic. 

This unique ability for hedge funds to position themselves both long and short regarding assets offers more advantages during volatile market conditions. This, accompanied by industry-leading risk management tools, provides the best possible alpha-generative capabilities to capitalize on market movements. 

Equipped with a globally-focused prime brokerage for hedge funds, it’s possible for institutions to expand their superior risk management to global markets, improving the access to alpha on a global scale as market uncertainty carries an uneven impact throughout different economies. 

Cautious optimism ahead

With geopolitical uncertainty and an increasingly tumultuous US presidential election looming, the world’s most resourceful hedge funds will undoubtedly be looking to the prospect of volatility in Q3 2024 and beyond as a unique market opportunity to consolidate growth. 

Despite this, the direction that US markets will take remains far from assured. This calls for a cautious approach to seizing opportunities thrown up by market conditions. 

However, with the backing of the best risk management tools within the trading landscape, more outperformance for hedge funds in the months ahead appears likely for the industry’s smartest players. Recession or no recession, the future appears bright for Wall Street’s biggest institutions.