The market is expecting fewer rate hikes from the Federal Reserve after last week's dovish meeting, and returns for both hedge funds and mutual funds are taking a hit because of it.
The Fed, concerns that the U.K. may potentially leave the European Union, and last month's poor jobs report in the U.S. have all caused the markets to price in lower interest rates for longer, with bond yields in Europe, Japan, and the U.S. all hitting multiyear (if not record) lows. A team at Deutsche Bank AG, led by Chief Global Strategist Binky Chadha, points out how this has damaged returns for actively managed equity and bond funds alike.
"The market has now almost completely priced out a rate normalization cycle, pricing only one 25 basis point hike over the next three years," the team at Deutsche Bank wrote. "Hiking expectations, which fell sharply during the first quarter growth scare, have not recovered even as various other market indicators and broader data have. In particular, rates have disconnected further from overall data surprises which are near neutral as the payrolls disappointment was largely offset by positive surprises in other data."
This "rate shock," as the team dubs it, has left 76 percent of equity mutual funds underperforming over the past two weeks, by an average of 64 basis points. On the hedge fund side, the team found that long-short funds were down 1.5 percent. Much of this underperformance is because these funds were caught betting on financials and against consumer staples, utilities, and telecom stocks. When the market prices in lower interest rates, financials tend to suffer while more defensive plays, such as consumer staples, perform better. Below is a chart from the note showing where mutual funds were positioned and how those sectors have performed since June 2.
Of course, it now looks as though many of these plays are reversing this week as concerns over Brexit are alleviated, with polls showing the increasing odds of a "remain" vote coming out on top. Here's hoping the funds haven't changed their positions only to be caught on the wrong side of those trades once again.