Hedge funds investing in credit are in demand

Published on14 MAR 2024

Firms that allocate assets are, for a second year in a row, more interested in hedge funds that invest in credit than in any other hedge fund strategy.

The demand for credit hedge fund strategies (which include the trading of assets like company debt, structured credit, and some sovereign instruments) comes after both bonds and stocks rallied last year, according to the Goldman Sachs Prime Services Hedge Funds Insights and Analytics team’s 2024 Hedge Fund Industry Outlook.

Capital allocators reported an average gain of 6.4% from their hedge fund portfolios between January and November 2023, up from a 0.9% loss in the same period in 2022. The report includes a survey of responses from 358 allocator firms globally, who control more than $1 trillion in assets allocated to hedge funds, as well as responses from 302 hedge fund managers who are clients of Goldman Sachs’ Prime Services business and collectively manage more than $1 trillion.

Which hedge fund strategies are in demand?

“If you had to point to one strategy that's definitely in favor at this point in time, it's credit,” Freddie Parker, co-head of Prime Insights and Analytics in Global Banking & Markets, says in an episode of Goldman Sachs’ The Markets podcast.

Some 44% of investors plan to increase their exposure to hedge funds with a credit strategy this year and only 3% plan to decrease it. Interest in other approaches, such as discretionary macro (which take a high-level perspective of global markets) and multi-strategy funds, has cooled, the report says.

Like last year, distressed credit and long-short credit (a strategy of betting on appreciation as well as depreciation in bond prices, often including hedging) were the most sought-after sub-strategies for hedge funds, according to the survey.

“The overall high-rate environment in the fullness of time should be better for hedge fund strategies,” Parker points out on the podcast. Hedge funds’ performance historically improves during times of higher interest rates because they tend to produce lower correlations within stocks and bonds and a broader range of potential outcomes for investments. That gives fund managers more opportunity to generate better-than-average returns.

After seeing a notable decline in interest in hedge fund strategies focused on technology, media, and telecommunications (TMT) last year, demand for hedge funds investing in this sector has rebounded and is now the most sought-after. However, the report points out this may be because allocators are changing their rosters of TMT-focused managers rather than increasing their exposure to the strategy.

In addition to TMT, demand for energy- and utilities-focused funds remains relatively strong, while interest in healthcare and biotech has declined, the report says. At this point, just 14% of allocators plan to increase their exposure to healthcare-focused managers, compared with 26% in 2020, when healthcare was one of the most sought-after hedge fund strategies.

Which geographies are hedge fund-allocators investing in?

Allocators’ interest in Asia continues to cool as well. Demand for the region peaked in 2021, with almost half of allocators surveyed expressing interest in increasing their exposure to Asia. Now it’s the least sought-after, falling behind Europe and North America. However, within Asia, interest has increased slightly for Japan and pan-Asia strategies at the expense of demand for China, which continues to decline. China accounted for just 9% of allocator interest in regional strategies for 2024, down from about 30% in 2020, the report says.

This year is the first time in many years that appetite for Europe outpaces the other two regions, with 17% of allocators saying they will increase their allocation there. That said, the level of absolute demand for Europe fell year-over-year for 2024, from 20% the year before.

The report also captures a shift taking place among the type of investors that allocate to hedge funds. Pensions and insurance companies, which were bullish on hedge funds last year, have pulled back. Just 17% plan to increase exposure in 2024, down from two-thirds in 2023, the report says. 

“The principal driver of this shift is the rise in rates pushing many corporate pensions towards fully funded status — which encourages them to [reduce] risk and move toward liability matching — coupled with the increased viability of fixed income,” the report says. As pensions and insurers decrease their exposure, endowments and foundations are raising theirs, boosting allocations to the highest in five years.

Hedge funds underperformed 60/40 portfolios in 2023

Last year hedge funds underperformed traditional 60/40 portfolios (which allocate 60% of funds to the S&P 500 Index of stocks and 40% to 10-year US Treasury bonds) by the widest margin since 2000. Hedge funds came into the year defensively positioned and struggled to keep pace.

Even so, the report notes that investors remain committed to hedge funds and are optimistic about their prospects in the longer term. Demand remains robust on an absolute basis, as only private credit and long-only fixed income surpass hedge funds among allocators’ plans.

“Overall, I think hedge fund sentiment remains very constructive,” Parker says. “The problem is that there is a shortage of liquidity right now. What we're hearing from investors is they'd like to do more in hedge funds, but there's not a lot of available cash in portfolios to deploy.”

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