By Nell Mackenzie

LONDON Investors expect hedge funds to produce higher returns with the prospect of interest rates staying higher for longer, a BNP Paribas investor survey showed on Wednesday.

Interest rates in big developed economies have shot up since late 2021 to contain inflation, with resilience in the U.S. economy adding to a sense that rates will likely stay higher for longer.

Investors now expect hedge funds to return an average of 9.75% annually within an average of 19 months, up from 6.85%, according to the survey.

However, hedge funds themselves think this will take longer, up to 29 months, the survey showed.

BNP Paribas said historical evidence shows hedge funds tend to perform well in higher and stable interest rate environments and less so when rates are lower.

When central banks are in a tightening or loosening cycle, hedge fund performance is not correlated to rising and falling rates, it added.

Stripping away the general rise in the MSCI index of world stocks, hedge funds posted on average a 1.10% better performance than three-month Treasury bills from January 2022 to August 2023, BNP Paribas said.

Only four of the central banks overseeing the 10 most heavily traded currencies held rate setting meetings in August. Until then, the total 2023 year-to-date tally for G10 central banks was 1,075 bps of tightening across 33 hikes.

Most of the hedge fund managers interviewed agreed with their investors about potential returns and 62% said they should outperform the risk free rate by 6% or more.

Nearly half of the investors surveyed planned to move money to a different hedge fund strategy they thought would outperform in a higher rate environment.

The strategies of choice included systematically traded commodity trading advisors, corporate bond trading and actively managed macro economic portfolio trading.

Lacklustre returns might ultimately turn investors' attention from the hedge fund industry to other kinds of investments considered alternative but with better performance, suggested family office investor Michael Oliver Weinberg.

“Even if hedge funds achieve a 10% net return with 5% returns on cash, that's only a 5% return from risk. Whilst today one can get higher equity like returns with credit like risk from senior, covenant heavy, secured private credit and real estate,” said Weinberg.

BNP Capital Introduction Group surveyed 82 hedge fund managers in what it called the "summer" of 2023.

(Reporting by Nell Mackenzie;Editing by Dhara Ranasinghe and Kirsten Donovan)