The U.S. dollar made a major directional move higher between July 2014 and March 2015, adding gains of approximately 14% as the domestic economy gradually began to demonstrate signs of improvement. The currency then began to sell-off in early 2016, as interest rate rises were not as forthcoming as many investors had anticipated, allowing questions to resurface about the true health of the U.S. economy. The dollar appreciated approximately 3.5% in May 2016 as the Federal Reserve Bank became more hawkish in regards to a June 2016 interest rate rise. The recent rise in the dollar has taken a number of hedge funds by surprise.
Hedge Funds Short
Many of the strategies used by hedge funds are quantitative-based, meaning trading opportunities are generated by using a complex mathematical analysis of data. Price data is a key metric often used by hedge funds when developing trading strategies. As the dollar was in a downtrend between January 2016 and April 2016, many of these strategies generated short signals that have subsequently resulted in short positions being initiated by a number of hedge funds. The dollar's rally has resulted in these funds being down approximately 3.4% in May 2016. Hedge Fund Analytix, a company that tracks industry trends, reports that short interest in the dollar is as high as it has been since 2011. Not only have losses occurred in trading the dollar directly, but funds that have taken recent positions in dollar-denominated assets, including commodities and/or U.S. Treasurys, have come under pressure as the dollar advanced in May 2016.
Hedge Fund Returns
Graham Capital Management’s Tactical Trend fund, which essentially follows market direction, was down 2.7% in May and is down approximately 7% year-to-date (YTD). It is a similar story for Lynx Asset Management’s Lynx fund that declined by 2.1% in the first half of May 2016 after being predominantly short of the dollar.
R.G. Niederhoffer Capital Management’s commodities-focused diversified fund experienced a decline of 3.3% in the first half of May 2016, largely due to its exposure to metals and agriculture. Commodities have come under considerable pressure, as the demand has been curbed from a rising dollar. Man Group PLC (OTC: MNGPY) AHL Diversified fund declined by approximately 3.6% in May 2016 as investments in stocks and fixed income weighed heavily as the dollar rose.
There are, however, funds that are exhibiting positive returns due to remaining bullish on the dollar. London-based H2O Asset Management, which has $7.6 billion in assets under management (AUM), continues to see a favorable outlook for the dollar based on the macro theme of rising inflation. The fund manager believes the current low headline unemployment rate of 4.7% in May 2016 is likely to push inflation higher, supporting the need for further interest rate hikes. The fund returned 1% in the first half of May 2016.
Ostracized Industry
Recent losses incurred by hedge funds due to the rising dollar are likely to exacerbate already-skeptical investor views about the performance of these funds. In the first quarter of 2016, hedge funds have encountered the largest quarterly outflow of funds since 2010. Major investors in the industry, such as China Investment Corp, are questioning hedge fund managers’ capabilities to navigate modern complex market environments. Industry insiders believe a high fee structure that typically consists of a 2% management fee and 20% performance fee is contributing to Investors shying away from hedge fund investments. Challenging conditions facing the industry have made veteran hedge fund manager Leon Cooperman, CEO of Omega Advisors, contemplate the longevity of hedge funds.
The Bottom Line
With interest rate rises not materializing as quickly as many investors had expected, the U.S. dollar began to fall in early 2016. This led many hedge funds to invest in dollar short exposures using various investment instruments. The May 2016 dollar rally caught these hedge funds by surprise, putting downward pressure on investment returns. Lackluster performance, excessive fees and increased regulation are key reasons cited by industry professionals for investors losing their appetite for hedge funds.
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