Why hedge funds are regaining their luster

What role do hedge funds play in a client’s portfolio?

Every asset allocation model needs three primary inputs: investments that drive returns, generate income, and offer diversification. Within alternatives, private equity clearly falls into the first category and private credit the second. Hedge funds, most typically considered as a diversifying asset, can also provide clients the opportunity to enhance returns (e.g. long-biased or activist equity) and deliver alternative yield (e.g. securitized credit). However, the primary role of hedge funds is to deliver better outcomes through diversifying return sources, uncorrelated to stocks and bonds. This is especially valuable during periods when traditional assets are themselves positively correlated, as has been the case over the past several years.

How do hedge funds perform?

The spread between top- and bottom-performing hedge funds, like in private markets, varies dramatically so it’s hard to generalize. However, certain conditions typically help or hinder the returns of most strategies. Case in point: during the zero-rate environment, risk assets appreciated considerably, and fixed income functioned as a flight-to-quality hedge. When correlations and equity valuations are high and credit spreads tight, hedging strategies are likely to underperform.

More recently, with higher rates, wider spreads, and elevated volatility, many hedge funds have performed far better, with the ‘average’ hedge fund up roughly 15% over the trailing 12 months, referenced by the HFRI Fund Weighted Composite Index.

How is the emergence of ‘mega-funds’ affecting the market?

Historically, significant asset growth often precedes declining performance, via muted returns or greater downside volatility. However, several of the largest, multi-billion-dollar hedge funds are delivering uniquely high-quality results for clients. The three reasons are: carefully managed growth, with tremendous foresight on capital deployment and liquidity management; continuous reinvestment in operational infrastructure, better risk systems, enhanced data analytics, etc.; and strong alignment of interest, with assets matching liabilities and significant GP capital invested alongside LPs.

Should those factors persist, we expect many of these ‘mega-funds’ to remain an incredibly valuable alternative in client portfolios.

What is a key trend that you foresee over the next five years?

When many hedge fund strategies ‘underperformed’ in the low interest rate environment of the 2010s, some investors concluded that the hedge fund approach had lost its luster. We believe that market factors ultimately drive opportunities – good and bad – and the outlook for many hedge funds is ‘opportunity-rich’. We expect to see more funds and structures coming to market making it easier for all clients, not just institutional and UHNW investors, to gain access to top-tier funds.

Which strategies are best positioned for 2025?

We see a continuation of higher returns and greater diversification in equity sub-strategies like quantitative trading, and in credit-based funds that specialize in securitized credit. Relative to fundamental stock-picking and fixed income investing, these areas provide differentiated return sources away from ‘traditional beta.’

At a broader strategy level, we maintain our positive outlook on macro and multi-strategy investing. Discretionary and systematic macro trading can take advantage of increases in market volatility across multiple asset classes globally, with the ability to protect against losses given their focus on liquid trading instruments. Multi-strategy can similarly monetize these opportunities on a market-neutral basis, resulting in high returns with low volatility. Accessing return sources independent of the direction of long-only stock and bond markets should add significant value to client portfolios in 2025 and beyond.

About
Joseph Burns focuses on the identification, selection, and due diligence of hedge funds. Before joining iCapital’s mission to broaden access to alternative assets, he was Chief Operating Officer at TCS Capital Management, a global equity hedge fund where he focused on portfolio construction, risk management, and business development.

_{This article originally appeared in Preqin 2025 Global Report: Hedge Funds. The opinions and facts included in the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin and iCapital accept no liability for any decisions taken in relation to the above.}