Hedge funds are currently benefiting from the volatile investment climate, growing interest from pension funds, and technological advances, making them a valuable tool for generating alpha.
2024 was a profitable year for hedge funds, as uncertainty in the markets paved the way for them to achieve their strongest performances for a long time. Returns of 10% in 2025 look plausible, whereas traditional credit investments, for example, may be affected by high interest rates and persistent inflation.
In these circumstances, hedge funds are becoming a crucial portfolio component for diversifying sources of return and exploiting opportunities offered by credit market dispersion, fixed-income arbitrage and various strategies designed to take advantage of volatility. In addition, with the US market now highly concentrated in the tech sector, hedge funds provide a distinctive way of achieving effective risk management by avoiding the Magnificent Seven.
Growing pension fund interest in hedge funds
Pension funds – which historically are cautious investors – are gradually increasing their exposure to hedge funds to better diversify their portfolios and achieve returns uncorrelated to traditional asset classes.
Given the reduced attractiveness of bonds due to interest rate volatility, these institutional investors now see hedge funds as a strategic alternative that combines inflation protection with growth potential.
However, this growing interest comes with increased vigilance in terms of transparency, fees, and risk management, as pension funds are subject to strict fiduciary requirements. Debate continues about the relevance of these investments, particularly given the sometimes-limited transparency of hedge funds and their fee structures, which are often higher than those found in traditional asset management.
Nevertheless, the trend reflects a growing desire and need on the part of institutional investors to allocate a greater proportion of their assets to these alternative strategies, given their diversification and risk-adjusted return benefits. At the same time, the complexity of investing in funded pension schemes means that specialist advice needs to be sought.
Generative AI: a boon for finance
Interest in artificial intelligence (AI) has considerably increased since OpenAI's launch of ChatGPT in 2022, which highlighted the power of large language models (LLMs) and generative AI (GenAI). This has caused a surge in valuations for companies like Nvidia. However, GenAI is part of a broader range of machine learning (ML) methods, which themselves form part of an ecosystem that has been widely applied in the finance industry for several years now.
AI plays a central role in quantitative strategies, in which deep-learning capabilities are used to establish complex relationships between financial data. The distinguishing feature of quant funds is that they use a fully systematic investment process, which is intended to reduce human intervention to a minimum.
Whereas traditional quant strategies used statistical methods to predict market movements, specific ML-based funds have been emerging since the 2010s, making forecasts based on relationships that are often beyond human analysis. For managers who can master them, ML models – although less explainable and more prone to overfitting – offer real potential to generate differentiated, attractive alpha.
Hedge funds and the opportunities of AI
GenAI is used much more broadly in hedge funds, in both investment and non-investment processes. This technology excels at summarising and generating text, which makes it particularly useful in processes that involve non-structured textual data, and that are repetitive, low-risk and easily checked by humans.
In the investment field, the use of GenAI is focused on generating alpha by improving managers' ability to analyse a vast range of information sources, such as earnings calls in foreign languages, through advanced natural language processing (NLP) capabilities.
For long-term projects, GenAI can speed up the research process, from generating ideas to assessing returns on investment. In support functions, it allows significant efficiency gains. In particular, it helps IT teams to write code, and operational, legal and investor-relations staff to summarise documents, as well as improving internal communication through automated meeting summaries.
Significant room for improvement
However, hedge fund managers face several challenges in using AI, including its tendency to ‘hallucinate’ which involves producing inaccurate content. There are also other concerns relating to consistency, reliability, data security, compliance and regulatory issues.
Despite these challenges, the rapid development of AI is expected to deliver ongoing improvements, with large amounts of resources being invested by asset managers and in foundation models. GenAI is seen as a tool for increasing managers' existing capabilities rather than as a way of fundamentally transforming them.
As regards investment strategies, quantitative hedge funds have a long history of using ML methods to generate pure, uncorrelated alpha. However, as a process tool, GenAI is now having a greater impact on the whole industry, and managers across all strategies are exploring how to apply it.
Although its usefulness is currently variable, GenAI is showing the greatest potential in generating and summarising low-risk text. As a result, even at this early stage, and even if it is limited to specific tasks, it is already playing a significant role.
