Global Investment Strategy
Global Investment Strategy Report
January 23, 2017
Justin Lenarcic
Global Alternative Investment
Strategist
Weekly market insights from the Global Investment Strategy
team
» There have been some similarities between trends in hedge
fund performance and the fed funds target rate over time.
» Both hedge fund performance and U.S. equity-return
dispersion likely have been suppressed by historically low
interest rates.
What it may mean for investors
» We anticipate an improving opportunity set for hedge fund
investors, driven in part by the potential increases in the fed
funds target rate, coinciding with broadening economic
growth, rising inflation, and an increase in volatility.
Linking Monetary Policy to Hedge Fund Performance
The deterioration in hedge fund performance seen since the financial crisis of 2008-2009 is often
attributed to high fees, rampant industry growth, or a lack of alpha-generating ideas. But interest rates,
specifically the federal funds rate, may be a more pernicious, yet often overlooked, influence. We
anticipate an improvement in hedge fund performance as the federal funds rate moves higher.
Chart 1. HFRI Four-Year Annualized Hedge Fund Returns versus Federal Funds Rate
7.0%
20.0%
18.0%
6.0%
Federal Funds Rate (%)
5.0%
14.0%
12.0%
4.0%
10.0%
3.0%
8.0%
6.0%
2.0%
Four Year Annualized Returns (%)
16.0%
4.0%
1.0%
2.0%
0.0%
0.0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Federal Funds Rate (Left Hand Scale)
Four Year Annualized Return (Right Hand Scale)
Source: Wells Fargo Investment Institute, Bloomberg, 1/17/17. Chart is for illustrative purposes only and does not represent actual performance achieved by any investor. The
federal funds rate is the interest rate banks charge each other on loans used to meet reserve requirements. Past performance is no guarantee of future results. An index
is unmanaged and not available for direct investment.
© 2017 Wells Fargo Investment Institute. All rights reserved.
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Global Investment Strategy—| Linking Monetary Policy to Hedge Fund Performance—|—January 23, 2017
Chart 1 compares the federal funds rate with the four-year annualized returns of the HFRI Fund
Weighted Composite Index (the Index). 1 (Four-year periods are used as they reflect the average length
of several recent monetary easing cycles.) This chart unveils an interesting relationship. As short-term
rates declined from January 2001 through May 2004, hedge fund annualized returns as represented by
the Index were cut in half, declining from 13.4 percent to 6.4 percent. A similar, though more significant,
deterioration in performance occurred from September 2007 through November 2015. During that
period, the federal funds rate declined from 5.25 percent to 0.25 percent, while the four-year annualized
return of the Index declined from 11.5 percent to 4.5 percent.
Fortunately, recent history suggests that hedge fund performance may improve as the federal funds rate
increases. From June 2004 through August 2007, the federal funds rate rose from 1.25 percent to 5.25
percent, while the four-year annualized return of the Index nearly doubled from 5.7 percent to 11.0
percent. We believe that there may be multiple reasons why hedge fund performance improved as the
federal funds rate rose. For instance, managers likely benefited from stronger economic growth, higher
inflation, more carry (or yield) from fixed-income positions and an increase in both volatility and trends
in global credit and equities.
Yet, we do believe that there also is a link between the federal funds rate and dispersion in equity
performance, as shown in Chart 2. The decline in return dispersion for the S&P 1500 Index coincided
with the U.S. monetary easing cycle experienced from January 2001 through May 2004. Domestic
interest rates have remained at historically low levels for the past seven years as both quantitative
easing and the Federal Reserve’s zero interest-rate policy (ZIRP) are likely to have influenced asset
prices. While it may be tenuous to claim that a rising federal funds rate can lead to greater dispersion in
equity-market returns, we do believe that accommodative monetary policy has the tendency to reduce
return dispersion and partially mitigate the benefits of security selection.
Chart 2. Dispersion in S&P 1500 Index Monthly Return versus Federal Funds Rate
135%
125%
6.0%
Federal Funds Rate (%)
115%
5.0%
105%
95%
4.0%
85%
3.0%
75%
65%
2.0%
S&P 1500 6 Month Return Dispersion (%)
7.0%
55%
1.0%
45%
0.0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Federal Funds Rate (Left Hand Scale)
35%
S&P 1500 6 Month Return Dispersion (Right Hand Scale)
Source: Wells Fargo Investment Institute, Weiss Multi-Strategy Advisors, LLC, Bloomberg, 1/17/17. Past performance is no guarantee of future results. An index is
unmanaged and not available for direct investment.
Recent easing cycles include July 1990 through January 1994 (43 months); January 2001 through May 2004 (41 months); and September 2007 through November 2015 (99
months).
1
© 2017 Wells Fargo Investment Institute. All rights reserved.
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Global Investment Strategy—| Linking Monetary Policy to Hedge Fund Performance—|—January 23, 2017
Investment Implications
Assuming that U.S. economic growth remains stable, we anticipate two increases in the fed funds target
rate in 2017. (Our year-end 2017 target range for the fed funds rate is 1.00-1.25 percent.) These federal
funds rate increases may help to be a positive, short-term driver for hedge fund performance. The
expected rise in market volatility this year, leading to periodic dislocations in asset prices, we believe,
should further bolster the opportunity set for hedge funds. We suggest that qualified investors who are
concerned about the impact of rising interest rates on their portfolio consider the historical relationship
between hedge fund performance and the federal funds rate.
Risks Considerations
Hedge funds are complex, speculative investment vehicles and are not suitable for all investors. They are generally open
to qualified investors only and carry high costs, substantial risks, and may be highly volatile. Any offer to purchase or sell
a specific fund will be made by the product's official offering documents. Investors could lose all or a substantial amount
investing in hedge funds. There is often limited (or even non-existent) liquidity and a lack of transparency regarding the
underlying assets. They do not represent a complete investment program. Hedge funds are not required to provide investors
with periodic pricing or valuation and are not subject to the same regulatory requirements as mutual funds. Hedge funds trade
in diverse complex strategies that are affected in different ways and at different times by changing market conditions.
Strategies may, at times, be out of market favor for considerable periods with adverse consequences. An investment in a hedge
fund involves the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use
of leverage, short sales, derivative instruments, investments in non-U.S. securities, “junk” bonds and illiquid investments.
Definitions
HFRI Fund Weighted Composite Index is a global, equal-weighted index of more than 2,000 single-manager funds that report
to the HFR (Hedge Fund Research) database. Constituent funds report monthly net-of-all-fees performance in U.S. dollars and
have a minimum of $50 million under management or a 12-month track record of active performance. The HFRI Fund Weighted
Composite Index does not include funds of hedge funds.
The S&P Composite 1500® Index combines three leading indices, the S&P 500®, the S&P MidCap 400®, and the S&P SmallCap
600® to cover approximately 90% of the U.S. market capitalization. It is designed for investors seeking to replicate the
performance of the U.S. equity market or benchmark against a representative universe of tradable stocks.
Disclosures
Global Investment Strategy and Global Alternative Investments (GAI) are divisions of Wells Fargo Investment Institute, Inc.
(WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo & Company and provides
investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank,
N.A. is a bank affiliate of Wells Fargo & Company. Global Alternative Investment Services, Inc. is a registered broker-dealer
that acts as placement agent for certain funds and provides wholesaling support services to GAI.
The information contained in this document has been prepared by Global Alternative Investments (GAI) and the
opinions are those of GAI. The views expressed are subject to change and are not intended as investment advice. GAI
does not undertake to advise you of any change in its opinion or of the information contained herein. The information or
analysis contained in this material has been compiled or arrived at from sources believed to be reliable but GAI does not
make any representations as to their accuracy or completeness and does not accept liability for any loss arising from the use
thereof.
Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory
Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S.
residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain
protections conferred by legislation and regulations in their country of residence in respect of any investments, investment
transactions or communications made with Wells Fargo Advisors.
Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial
Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.
CAR 0117-03787
© 2017 Wells Fargo Investment Institute. All rights reserved.
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