Faced with conflicting signs over where financial markets are heading, investors often get caught in trends that result in vicious swings in their investment portfolios when there are ways to avoid these pitfalls, writes Kagiso Mathole, portfolio manager, Novare Investments.

Emotions such as doubt and fear are your worst foes when investing. Herd mentality is why stocks often surge above their actual worth or plummet below their intrinsic value. Here’s where hedge fund managers can step in – they’ve learned to navigate the opposing forces of euphoria and panic, restore balance, and reduce risk in an investment portfolio.

Gone are the days when hedge fund managers were considered masked, reckless cowboys who stormed financial markets all guns blazing, only to leave behind a wake of dust and destruction.

The industry is regulated (and has been for over eight years), more transparent (by offering real-time or daily prices, information about risk exposures, and details on fees), and clear about investment strategies, benchmarks used to measure returns, and objectives.

It’s not that hedge fund managers are necessarily better than traditional managers; they have a more comprehensive array of investment tools that allow them to profit from falling asset prices, overcome market volatility and smooth out returns.

Hedge funds bring immense diversification benefits to retirement funds and should account for a more significant percentage of portfolios than they currently do. A hedge fund aims to generate returns uncorrelated to market indices and consistent with investors’ appetite for risk.

Consider the current state of markets. Of course, 2022 will be remembered as the year when $14 trillion of value was wiped off global equities, according to Reuters. Also, for when bonds had their worst year on record, Barclays data shows. But that doesn’t make picking winners and losers in the last few months of 2023 easier, especially if you’ve moved savings offshore and are considering your next move.

Significantly overvalued

US stocks have risen so sharply this year that they are now “significantly overvalued”, according to the Buffett Indicator, a measure named after the famed billionaire investor Warren Buffett, which expresses stock market valuations as a percentage of GDP. Excitement over artificial intelligence (AI) and misplaced hopes that the Federal Reserve (Fed) could cut interest rates this year fuelled the rally.

Despite inflation coming off its peak, US companies are still saddled with higher input costs and debt levels when interest rates are at a 22-year high. As far as AI is concerned, aside from apparent names like Nvidia, it’s tough to pick clear leaders. Besides, with the full benefits possibly taking years to become fully apparent and the cost of implementation potentially large, the rally can sputter out as quickly as it started.

At the same time, US government bond yields are trading near their highest levels since 2008, making them more attractive than stocks from an income perspective.

There is a disconnect between the US stock and bond markets. It’s unclear how long the economy can continue chugging along as strongly as it is, which is what the stock market is pricing. The bond market is bracing for an environment where interest rates stay higher for longer. Stock markets seem to be betting on lower rates.

In contrast to the US, China’s much-vaunted economic recovery is in tatters. Unlike the rest of the world, China is battling deflation, when prices fall throughout the economy. The government has stepped in with various stimulus measures to spur growth, and the central bank has unexpectedly cut interest rates.

Its challenges are compounded by a political standoff with the US that has soured relations with the West and stalled foreign direct investment. Even so, the government forecasts economic growth of 5% this year; a target Fitch Ratings expects it to hit as infrastructure investment and consumption improve.

Not to be ignored

China, the world’s second-biggest economy, cannot be ignored, and it can bounce back at the same rate it retracted. The Buffett Indicator considers Chinese stocks “fair valued”, with an expected annual return of 8.3% compared with 1.2% for the US.

Opportunities and threats are in the eye of the beholder but need careful sifting through. Local opportunities here at home also exist; some stocks would benefit from the US doing well, and others would gain from China’s success. South African bonds are also offering high returns.

But to buy shares or bonds and hold onto them no longer works on its own.

That’s why hedge fund managers use strategies such as shorting stocks, in which a share is sold to repurchase it later at a lower price; put (or call) options, which give the holder the right to sell (or buy) an asset at a specified price by a predetermined date; or, fixed-income arbitrage, a tactic that involves taking advantage of price differences between related bonds.

Financial advisers, trustees of pension funds, and retail investors must understand what they’re getting into before committing a part of their clients’, members’ or their own portfolios to hedge funds. As multi-managers, we at Novare analyse and select hedge fund managers with proven track records, diverse strategies, and robust risk management processes before committing assets from our pension fund clients.

We aim to ensure investors preserve their capital and get the maximum returns with the least risk. When you are betting on human behaviour to profit from a position you’ve taken in a stock, for example, a hedge fund manager must resist the same instincts driving the person on the other side of the trade.

It’s a high-stakes game. To twist a phrase: feelings don’t matter when it comes to fundamentals.