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3 Impacts of Rising Short Term Rates

The Federal Reserve hiked rates in March by 25bps to 1.5—1.75% marking the sixth uptick since December 2015. It’s set to increase them even more over the next two years, which could result in a rate rise of 3.5% by 2020.

The upshot of rising short term rates could have a positive impact for hedge funds, but the main thing to focus on will be what happens to the cash; AlphaWeek takes a look at the possible impact of rising rates.

Strategies with large cash positions will do better than those without

Strategies with large cash positions will grow their market share of the hedge fund industry at the expense of other strategies, according to Don Steinbrugge, CEO of Agecroft Partners.

He explains that most allocations result from investor’s evaluation of strategies and managers, as to which offer the best opportunity to add value. 

“These decisions inform not only new allocations, but reallocations from existing managers. Often there is only a 1-2% difference of the expected return among potential hedge fund strategies on an investors’ shortlist. In a rising interest rate environment, the enhanced returns from strategies with large cash positions should make these strategies significantly more attractive.”

Rising rates will boost hedge returns

Higher cash rates will boost hedge returns as their assets are often held in cash like collateral, but it will have no impact on fees as fees are libor plus a return, according to Peter Sleep, senior portfolio manager at 7IM.

He gives the example of a long-short fund wanting to go long on VW preference stocks that are cheap and short VW ordinary stocks that are expensive.  This could be done in a number of ways but the obvious way is to buy the VW preference stocks outright.  Then they would borrow and sell VW stock and put the cash proceeds up as collateral on which they earn money, which is paid by the person lending the stock.  There is some slippage for fees on the loan, but they earn on the cash collateral, which in a stock loan transaction will typically be Libor. 

“The higher the cash rates, the higher absolute level of earnings they make from this transaction, assuming minimal slippage rates and no movement in VW ordinary stocks or their preference stocks.  Thus the overall level of earnings to the hedge fund industry should go up, although the earnings of the hedge fund partners will not change,” he said.

Rising interest rates generally creates volatility which affords better price dispersion for trading-oriented hedge fund strategies.

Kamal Suppal, chief investment auditor at Emerging Market Alternatives, warned that “an improving climate for “alpha” comes mixed with the potential for rising rebates on shorts due to higher cash yields. Hence investors should clinically audit the return attribution before awarding performance fees, which ought to be predicated on alpha generation above cash and similar hurdles.”

Fee negotiation

This question around fees is likely to rear its head. Steinbrugge believes that institutional investors will ask for a performance hurdle for the carried interest portion of performance attributable to the cash position of the portfolio if short term rates continue to rise as expected.

There has been significant pressure on fees in recent years as a result of poor performance with some managers offering fees of one and fifteen, as opposed to the traditional two and twenty, while some have a 0% management fee.

DWD Partners, run by Danny Dayan has a 0% management fee. The aim is to align the structure of the hedge fund with the manager and investors. “We are incentivised to produce attractive returns and minimize losses, not hoard assets,” he says.  Investors are also offered a choice of different pay-outs.