Hedge funds and AI

 

HedgeWeek with Arcesium published a survey titled "Age of AI II: Understanding Hedge Funds' AI Capability versus Usage." It is a short piece, but what stood out for me was the interesting fact that smaller firms are embracing AI use more than large firms. The smaller firms are not only more active users but also seem willing to train employees in AI use. They are usng technology to potentially punch above their weight. The large firms do not seem as agile in using AI and are more concerned with data and output integrity. Will this translate into better returns? Harder to measure, but AI may be a disruptor to hedge funds.

Hedge fund strategy rebound

 

There has been a strong rebound in hedge fund strategy performance in April after poor March returns. All the HedgeIndex Main strategy returns were positive for the month, with especially strong performance in emerging markets, global macro, and long/short equity. Of course, the overall equity market showed strong April gains, so the market exposure for these strategies provided a tailwind, and positions placed at the end of the market were able to take advantage of the stock market improvement despite the continued uncertainty associated with the Iran War.

Tax loss alpha is getting big

 

There has been an increase in stories about tax alpha and how this has become a big thing in the hedge fund industry. Hedge funds are not tax effciency. The active trading in many funds generates positive returns, but capital gains may be limited, so returns are generally treated as ordinary income. Managed futures will have some tax advanatges, but the general case is that invetsors should compare after-tax returns across strategies. 

The question is who should be generating the tax alpha - the manager or the investor. The answer is to look at some combination of both, There is the old adage by Buffet about the two rules of asset management: Rule 1 protect principal, and rule 2, follow rule 1. 

Of course, the top priority is for any hedge fund is generate return, yet, tax efficicny should be a goal that can provide improved returns without significnat risk. For those who have SMAs, the tax efficiency can be achieved by the investor and viewed more holistically. Wash sales, tax loss harvesting, and forms of tax defferral can all help reduce tax drag. As more "retail" investors get involved in hedge funds, the issue of tax efficiency will come to the forefront. 

Asset allocation of university endowments

 

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A recent survey from NACUBO-Commonfund Study of Endowments provides interesting insights into the asset allocations for university endowments. Clearly, the larger funds have allocated more to alternatives and private assets and less to bonds, while the smaller funds appear to follow a more traditional allocation.

Nevertheless, the performance of endowments is not markedly different from that of a 60/40 portfolio. In fact, over three years, the endowments underperformed the classic mix, and over ten years, only the largest endowments seem to have beaten the simple benchmark. Does that mean 60/40 is better? No, but it does indicate that adding alternatives should be done carefully, with an eye to how they may compare to a simple approach.

Hedge fund rotation in 2026

 

Every year, we see investors change their appetite across hedge fund strategies, and 2026 is no different. There generally is a momentum component to hedge fund allocations. Strategies with strong performance will see strong interest in the following year.

For 2026, we are seeing increased interest in European hedge funds and in multi-strategy and event-driven strategies. There is also increased demand for digital assets, but we believe the current sell-off has cooled interest in these strategies. Interest in multi-strategy strategies has been the strongest among hedge fund strategies over the last few years. The low volatility and strong Sharpe ratios have been the primary drivers, despite the strategy’s high fees.

Hedge funds taking on long equity exposure

Hedge fund strategies are often purchased because there are expectations that they will exhibit a beta similar to that of equity markets. Not all the betas will be the same, but they will generally run between .5 and .6 on the high side to zero or slightly negative on the low side. CTAs usually have the lowest beta but also likely have low alpha. 

These betas or correlations will change with market conditions. The hope is that if there is an increase in beta, it is not because hedge fund managers are chasing the equity market with momentum trades, but rather because they are showing some market-timing skill. Evidence on market-timing the overall market is weak, so there should be concern when hedge funds exhibit higher short-run correlations with equity markets. Of course, hedge fund managers may have timing skills, but this is not the reason why most managers are buying these strategies. 

Investors seek uncorrelated returns, so there is a general expectation that betas will be low and stable. Yes, that means that hedge funds will underperform versus the overall market on an absolute basis, but investors should not pay for unwanted beta.

 

Qunat versus macro framework - One example of differences

 

Here is an example of how one macro hedge fund looks at the quant versus macro playbook. It is a good depiction of those managers who closely link quantity work with discretion. This is not better or worse than a fully quant or discretionary style, but it shows these two are connected. 

Quants usually hold more positions and rely on the law of large numbers and diversification. If you follow the fundamental law of active management, the goal is to make many "uncorrelated" bets. Note that each sees the world differently with respect to how they view the world, form bets, and build portfolios.

The rise of alternatives with pensions - the great hedge fund demand increase

 

The key development for the hedge fund industry was a change in demand from institutional investors. The shift in risk-taking was the overall driver for pension behavior in the last 35 years. This change in risk-taking reduced exposure to fixed income and increased the desire to seek higher-returning investments with a similar low overall risk. This shift is presented in the paper, The Rise of Alternatives. 

The shift in risk allocation by pensions and endowments led to a considerable increase in hedge fund demand across all strategies, with two effects. One, money flows into hedge funds increased as expected from any shift in demand. Two, the institutional investors demand greater oversight through their due diligence, which has increased the demand for legal, compliance, and risk management. Hedge funds grew larger, more sophisticated, and more complex in response to this greater demand.

Alpha and cost containment - The value of AI

 

We have written about how hedge funds are trying to contain costs by trading more efficiently. We are also seeing cost containment and efficiencies through the use of AI. Similar to consulting, AI can make analysts more efficient at some of their core tasks through summarizing and sifting through data in reports. The use of AI through EDGAR filing is not new, but has become a core part of the work by both discretionary and quantitative researchers. 

AI is being used as:

• information summary tool
• focused search tool 
• quick news analysis tool
• pre-screening tool along with quant analysis 
• simple idea generator
• proprietary prompt tool 

While not a research replacement, AI is not a research adjunct that allows hedge funds to run leaner shops with less costs on junior analyst development. The objective is to make senior analysts more efficient by reducing drudgery. Many firms have spent money on proprietary prompt libraries that can be applied to stock sets to serve as an alternative filtering mechanism. This can be especially powerful when linked with proprietary databases.

Alpha and cost containment - trading costs

 

Hedge fund performance centers on alpha generation. Alpha can come in many forms, but one that is clearly dominating the attention of many firms is cost containment. The drive to cost containment is based on two key components. One, there is relentless pressure from institutional investors to cut fees. With fees always pushing downward, firms have to become more efficient. Second, as hedge funds increase their trading volume, transaction costs become an increasingly important area for potential value creation.

By cutting trading costs, there is an immediate gain in return that flows through to the bottom line, reducing performance and incentive fees. Lowering the bid-ask spread improves returns. Executing with less slippage again enhances performance. The gain from cost containment is generally immediate and does not have to wait until ideas embedded in trades generate returns. 

Cost containment is especially valuable to firms that are gaining scale. There can be specialized trading desks, centralized research, and risk management that can use economies of scale. All provide an edge that will squeeze out smaller firms that cannot gain economies of scale.

The changing value of diversiification

 

Hail the 60/40 stock/bond portfolio. It has worked, yet a recent AQR research piece, Diversifying and the Rearview Mirror,  suggests that the value of the 60/40 portfolio will change based on the variable Sharpe ratio of the stock-bond combination. There are times when diversification beyond the 60/40 mix is a drag and other times when it is needed. The average Sharpe ratio for the stock/bond mix is 0.4, so if the Sharpe ratio reaches 1 or falls below -0.5, it is likely to mean-revert. Hence, a selective diversification strategy is valuable. If you feel too good about your 60/40 mix and it feels like diversification is a drag, start diversifying, and if you think the 60/40 mix is proving to be wrong, it is likely to work in your favor. In practice, this is not easy to implement, but it is worth thinking through when to diversify.

Hedge fund leverage high

 

The recent Financial Stability Report shows that hedge funds have high leverage. Now, this is gross leverage, so there can be a significant amount of long positions offset by shorts, yet this high level can be an essential risk if market dispersion and correlation change. A mismatch between long and short risk can create significant exposure for hedge funds. 

What is interesting is the large increase in balance-sheet leverage among the most significant hedge funds. These would be the multi-strat pods. Their leverage has exploded over the last two years, while the leverage of smaller hedge funds has remained relatively stable.

Hedge fund performance mixed for October

 

Hedge fund return performance was mixed in October, with the overall HedgeIndex Main, a combination of all Hedge Fund managers asset-weighted, declining for the month. The stand-outs were with convertible arbitrage and Global Macro, while multi-strategy and emerging markets were a drag on performance.

The overall performance of hedge funds has been positive this year, with managed futures the only strategy not generating positive returns. 

Volatility good for hedge funds

 

Volatility measures risk. It also measures uncertainty or at least variation in opinions on valuation. Volatility is an opportunity because, if a manager has skill, it should be shown when markets are more volatile. If you make the right decision, you will be paid more; if you are wrong, the pain will be higher. Macro hedge funds can go long and short across asset classes, so they should be able to take advantage of volatile markets. The visual supports that case. 

Volatility is an opportunity for distinction with a manager and strategy. 

Liquid Alternative Beta (LAB) performance for August

 

The Liquid Alternative Beta (LAB) indexes, available from HedgeIndex, formerly Credit Suisse, offer a comprehensive view of the performance of various hedge fund strategies in August. All the hedge fund strategies were positive for the month. Returns were consistent with the overall market, SPX, which gained 2.03% for the month. The LAB indexes beat the S&P500 growth and momentum factor-based indexes. The global strategy and managed futures indexes were able to take advantage of the tail winds from positive international equities and bond returns. This places most strategies with positive returns for the year, except for the managed futures and liquid indexes. The managed futures strategy has started to find trends after a difficult first half of the year. 

The LAB indexes have lower volatility than the long-only benchmark strategies. 

The hedge fund industry - Changed with Bernie Madoff

In our last post, we focused on the upheaval to the hedge fund industry from the GFC. The downside risk caused surviving hedge funds to innovate through forming management structures that attempt to gain scale and scope. Size and diversification as a form of hedging downside risk.

In this post, we focus on the second major upheaval to the hedge fund industry - the Bernie Madoff scandal. While hedge funds realized that they needed to gain scale and scope to save their businesses. Investors demanded more professional management and a broader scope of functions, as seen in other industries, in response to the uncertainty within the hedge funds in which they invested. Call it the rise of super due diligence. Of course, the government increased regulation, but investor due diligence also rose in response to fraud. The costs, especially for running a small hedge fund, increased because investors were not going to pare back due diligence because the manager was smaller. In fact, the risk of failure or fraud was likely higher for smaller funds. 

The Madoff change led to stronger internal controls, legal, and compliance departments. There was also a greater demand for transparency and contact with the manager, which increased the need for investor relations and marketing. The demand for risk management and exposure reporting led to the creation of separate departments from the investment business. 

Once the demand for transparency and more formal due diligence took hold, hedge funds had to provide many of the same investor services as long-only managers. The market shifted assets to larger firms, which in turn led hedge funds to focus on scale and scope, adopting more formal organizational structures.

The hedge fund industry - Changes from the GFC

The hedge fund industry - Changes from the GFC

 

The hedge fund industry has undergone significant changes since the Great Financial Crisis (GFC), which have not received sufficient attention. The focus is usually on performance, yet it is essential to consider hedge funds as a financial industry, one that evolves and adapts to the market environment. 

Hedge funds have not really developed new ways of generating alpha. They have adopted a greater use of quantitative tools, which represents a significant innovation in enhancing existing methods for generating alpha. However, the real innovation has been the movement toward vertical integration, a widening of scope through product development, and the formalization of management structure. 

The hedge fund industry was not immune to the significant declines in returns from the financial crisis. Many firms went out of business, and many experienced severe declines in cash flows. Assets under management declined, and the expected incentive fees were reduced or eliminated. The industry had to change because the surviving focused star manager could not survive another downturn like the GFC. 

The choices were clear, no different from those in other industries that underwent upheaval. First, the innovation of the hedge fund industry was to diversify the firm's offerings. This could be the same fund but with a broader market focus. It could also be different products within the same asset class or across asset classes, or it could be some customized product with features set for a large client. Second, there was a need to gain scale and better control costs through better professional management. This could take the form of formal marketing. It could also be a separate legal and compliance department, as well as separate risk management and trading departments. 

The desire for scale and cost control meant that the small shop, with its focused manager or personality, needed to become a departmentalized, professionally managed organization. There was an end to personality and a shift to departments that focused on specific tasks, overseen by the manager/owner.

This process was observed in many other industries in the US prior to the turn of the twentieth century. This is the story of American business and its pursuit of scale and scope. The hedge fund industry is not special. It follows the pattern of other industries.

BlackRock suggesting higher allocation to hedge funds

The BlackRock Investment Institute announces that investors should increase their allocation to hedge funds. It is not clear what the rationale is for this increase. Equity markets are overvalued and bond yields are not expected to move lower. Private equity is facing liquidity issues. Hence, hedge funds are a safe haven by default. As a diversifier, hedge funds may do the job, but the story should be more nuanced. Stock-picking has improved with market dispersion, but many hedge funds have relatively high betas. If the market moves lower, hedged funds will likely also see lower returns, albeit muted. 

The choice of hedge funds and the allocation are related to a market view. If there is a view that equity and bonds will not perform because of the macro environment, investment strategies should be focused on managed futures and global macro. For equity exposure, market neutral should be preferred. 

However, there is a bigger issue associated with fund flows. If there is limited alpha, what will happen to returns if there is a major increase in fund flows into hedge funds? There has not been enough work on the flow effects on alpha returns. More money chasing the same number of opportunities will lead to lower returns. Part of good investing is being in strategies before the "big money" enters the trades. 

HedgeIndex July performance - generally on track

 

We look closely at the HedgeIndex Liquidity Alternative Beta indexes that are replications of the HedgeIndex Composite Index returns. As a liquid alternative, investors can get a quick look at performance before many hedge funds report their monthly returns. 

Returns were positive except the managed futures index, which continues to have a difficult time finding trends in the major futures markets. If there are no trends, the trend index will not make money. The other strategies continue to show positive gains. Nevertheless, the Liquid and Global Strategies are a weighted average of the other strategies and have been pulled lower in 2025 by the managed futures performance. 

While the SPX generated a return of more than 2% for the month, these liquid alternatives have a lower volatility than the market beta. The LAB indexes performed better than the low volatility index, which returned a negative 29 bps this month. These indexes are not supposed to beat the major risk factors but should add diversification to any portfolio. The equity LAB indexes performed better than the fixed income composite.

Hedge fund start-ups - a thing of the past

 

A CAIA post shows that private capital firms now outnumber hedge funds. In fact, the number of hedge funds has declined over the past decade. Hedge funds are not a growth business. This can be associated with the rise of multistrategy firms that will pick up talent in pods, as opposed to investing in individual firms. This has not happened in other areas of alternative investing. The performance across hedge funds is tighter than other alternatives, even though there are significant differences in strategies. 

The hedge fund industry is undergoing consolidation, with higher start-up costs and increased operating expenses. You have to ask whether someone wanting to start a hedge fund is a little crazy.