2021 Year In Review — Financial Markets and Hedge Funds — And a Look Ahead at 2022

Closing the books on 2021, investors are reconsidering their investment portfolios in light of soaring inflation, supply chain disruptions, labor market tightness, a hawkish Fed, and continued interest in soaring risk assets, including cryptocurrencies and DeFi.  Of course, everything in 2021 occurred against the backdrop of the still unfolding Covid-19 pandemic.

This article reviews the major forces that drove the financial markets in 2021, and analyzes the current factors and trends that will impact hedge fund investing in the coming year.

The Truth about Inflation – It’s Not Just a Blip on the Economic Radar Screen

High inflation hit home in late 2021 as an economic reality and not the “transitory” phenomenon that the Fed and administration had hoped.  The annual inflation rate jumped to 7% in December, 2021 – the highest rate in 40 years – and the consensus forecast among market analysts is that the CPI for the 12 months ending in January, 2022 will hit 7.3%. The annual inflation rate hasn’t been below 5% since back in early 2021.  Markets are closely watching upcoming announcements regarding year-over-year CPI gains for indications on the Fed’s next moves.

The housing market is one area where dramatic price increases are stretching affordability for many home buyers.  Rent prices are likewise skyrocketing – up 18% year-over-year, on average, nationwide, according to Apartment List.  The National Association of Homebuilders reports that softwood lumber prices set record-high price increases in both 2020 and 2021.  Builders are building at higher price points, contributing to a shortage of “starter” homes.

(It’s interesting to note that average hourly earnings  – which have increased four months in a row now – are increasing at a 6.9% annual rate, a virtual lock-stop match of the current inflation rate.)

Real GDP Growth and Supply Chain Problems

Supply chain interruptions continue to be problematic even when the supply chain backlog starts to loosen up.  While headline GDP growth numbers appear to show solid economic growth (6.9% GDP growth in Q4 2021), a deeper look at the numbers reveals that much of the growth is reflected from companies restocking low inventories.

The global supply chain will likely continue to be plagued with delays and shortages due to, among other things, protocols and limitations stemming from the Covid-19 pandemic.  Rising input prices, resource scarcity, labor shortages, and rising consumer demand are also responsible for an environment where prices on consumer goods are rising quickly.

Financial Markets in 2021 – A Runaway Bull and Crypto Goes Mainstream

2021 marked a major transition year for cryptocurrency and digital assets going mainstream among retail traders and even some governments. Institutional investors have been actively looking to make allocations to digital assets, although many are finding challenges fitting digital assets into established investment, due diligence, and compliance processes.

Crypto stocks, crypto ETF, and digital assets themselves saw significant gains in 2021. Bitcoin began 2021 at $28,000 and closed the year at $46,000. Ethereum jumped from under $1,000 to over $4,000. There was seemingly a new “next big DeFi” coin or application touted every week or so. Even crypto experts struggled to stay on top of the market as Non-Fungible Tokens (NFTs) exploded in popularity while most investors still had no idea what they were. The Coinbase (NASDAQ: COIN) IPO in April rang up a valuation of more than $85 billion and Tesla (NASDAQ: TSLA) amassed a stash of Bitcoin holdings worth nearly $2 billion.

The stock market bull could not be stopped in 2021. The S&P 500 Index ended the year up 26%, hitting 70 new all-time highs during the year. Since hitting a low in March 2020, the S&P 500 Index has doubled – from approximately 2,200 to approximately 4,400. Tesla stock soared from $700 to $1,200, finishing up the year at just over $1,000, as Tesla joined the handful of giant tech corporations with a market cap over $1 trillion.

Nearly 450 new ETFs were launched in 2021. That’s 50% more than the previous record high. The surge in new exchange-traded funds was accompanied by a record $900 billion in net ETF inflows.

Best-Performing Market Sectors and Asset Classes

The lingering Covid-19 pandemic continued to push the technology and health care sectors to the top of the pack – trends that seem likely to continue. Amazon (NASDAQ: AMZN), Etsy (NASDAQ: ETSY), and the like will continue racking up record profits from the marketplace transition to “stay at home” and hybrid work cultures. Pfizer (NYSE: PFE), Moderna (NASDAQ: MRNA), Johnson & Johnson (NYSE: JNJ), and other pharmaceutical companies continued to rack up big profits from vaccines and therapies aimed to tackle Covid-19. The financial services, real estate, and energy sectors all showed strong performance, each up more than 30% for the year.

2021’s best performing asset class award goes to commodities. Oil, agricultural commodities, softs, and copper all saw strong gains. Cotton futures have more than doubled in price since their 2020 pandemic low. Even though gold and silver investors were left waiting yet another year for an explosive up move, the benchmark Bloomberg Commodities Index pegged an overall gain of 28.3%, outpacing the S&P 500.

The strong year in basic commodities should be no surprise, given the CPI inflation numbers for the last half of the year, since increases in producer prices generally precede rises in consumer prices. Energy futures may outperform in 2022, as governments continue to move policy priorities away from fossil fuels and toward renewable energy alternatives. Analysts at Wells Fargo note that “energy transition policies (are) reducing energy capacity faster than demand can convert over to renewables.”

The Federal Reserve Transitions from QE to QT

The Federal Reserve continues its tradition of policy changes that seem aimed to close the barn door after the horse has already gotten out. Will interest rates rise in 2022? – Undoubtedly. Treasury yields have already jumped sharply higher (the 10-year Treasury Note yield recently hit 1.93%), and more and more futures market analysts are predicting that the Fed will go with a 0.5% interest rate hike in March rather than the previously forecast 0.25% hike.  Real rates (after accounting for the effect of inflation) are dismal and the Fed has vowed to tackle inflationary pressure head on, with most analysts now predicting a long series of rate hikes in 2022.

The Fed’s dismal track record controlling inflation does not bode well for its ability to keep inflation in check.  However, we are clearly in uncharted waters as the Fed seeks to unwind some of its $9 trillion balance sheet through “quantitative tightening.”  Supply chain disruptions and producer price increases will make the Fed’s job doubly hard.

Hedge Funds – 2021 Performance

We witnessed a record number of hedge fund launches in 2021. According to Hedge Fund Research, 189 new hedge funds were launched in just the first quarter of the year. That’s the highest quarterly growth seen since 2017. Many new entrepreneurs have been spurred to create new businesses as fund managers, encouraged by the strongest bull market in decades and a growing appetite among sophisticated investors for alternative assets. HFM Global reports surveys that show the majority of investors (roughly 3 out of 5) have a more favorable outlook on hedge funds than on any other asset class.

“Innovation” is one of the current watch words in the hedge fund industry. Top investment managers are innovating new strategies and ways to monetize emerging market dynamics across traditional asset classes and emerging, decentralized marketplaces.

However, emerging managers continue to face intense competition for capital and the threat of withdrawals if strategies underperform. Allocators continue to exert downward pressure on fees as they lobby for greater protections for investors, relative to historically GP-friendly norms.

Data from Preqin shows that several catalysts, including rising inflation, above average hedge fund returns, and a strong shift in investor attitudes in favor of alternative assets, helped drive hedge fund inflows totaling more than $50 billion in 2021. Managed futures and multi-strategy funds racked up the lion’s share of gains in 2021, together accounting for more than $40 billion of the inflow.

Hedge Fund Strategies That Outperformed in 2021

So, how well did hedge funds actually perform in 2021? Kenneth Heinz, president of Hedge Fund Research, reports that the top 10% of hedge funds nailed a 126% return for investors for the 12 months ending at the close of the first quarter. Funds pursuing event-driven or equity hedging strategies led the way, along with commodity-focused funds. The latest Preqin hedge fund performance report, issued in December 2021, echoes HFR’s findings, showing equity, multi-strategy, and event-driven strategies as the best performers in 2021.

Heinz believes that investors looking to hedge inflation risk will find event-driven and equity hedge funds offer an attractive combination of both inflation protection and high potential returns. Some fund managers generated outstanding returns simply by being excellent stock pickers. Case in point: Senvest Management, with $3.2 billion in assets under management (AUM), realized an 85% return for the year as the fund made one winning bet after another, winning on both long and short stock positions.

Hedge Fund Investors Have High Expectations for 2022

We are watching several trends related to what investors are looking to get from hedge fund investments in 2022.

• True Portfolio Risk Diversification. In the face of volatile markets, hedge fund investors are seeking investment strategies with minimal correlation to established markets and that have the potential to generate positive returns when equity markets experience rotation. This is increasingly important as more analysts and investors foresee the end of the “easy money” bull market that had been propped up by dovish Fed policies. As risk assets are repriced in light of rising interest rates, there is likely to be a greater focus on preservation of capital.
• Niche Expertise and Strategies. Many investors are seeking to realize optimal investment returns by investing in funds that concentrate on niche opportunities that have the potential to outperform, even as traditional investments face headwinds. Thus, we see a trend toward investing in funds that are focused on niche strategies, markets, and exposures.
• Digital Asset and Crypto Exposure. Cryptocurrency and blockchain investments are rapidly going mainstream even as investors cope with the extreme volatility of digital asset markets. Sophisticated investors are pursuing investments in promising blockchain and decentralized investments.  However, would-be investors are hampered by an uncertain regulatory environment, new paradigms in custody and safekeeping of assets, as well as traditionalist boards and decision-makers. Managers that attract assets in digital asset and crypto strategies will bring a mixture of investment acumen and operational competency to convince investors that the outsize return potential of DeFi and crypto assets are worth the well-publicized risks.
• A Good Fortuneteller. Investors are becoming increasingly convinced that widespread economic and market uncertainty are here to stay for the foreseeable future. These investors want a fund manager who can quickly adapt to, and thrive in, a wide variety of constantly changing market conditions, and who can generate alpha in even the most dislocated and bearish markets.

Hedge Funds in 2022 — Conclusion

Interest and investment in hedge funds set records in 2021 and we expect strong demand for hedge funds in 2022.  The changing interest rate environment, inflation, and the mainstream adoption of digital assets and decentralized applications are likely to be key market drivers this year.  Allocators are looking for innovative trading strategies, exposure to emerging asset classes and niche opportunities, and new ways to incorporate hedge fund investments into their portfolios.  Economic and market headwinds are taking shape but skillful investment managers will see an opportunity to differentiate their strategies against the broader market for risk assets.