Q4 2025: Don't Stop Believin'?

1. Introduction

The third quarter was characterised by risk assets grinding ever higher, despite multiple levels of uncertainty about the global political and economic system. At the time of writing, we have the US government in shutdown due to the inability to agree on a new budget; continuing wars in Ukraine and the Middle East; continuing erosion of democratic norms; weakening of the rules-based international order; the further rise of authoritarian populism across much of the developed world; and political attacks on the independence of both the Federal Reserve and the Bureau of Labor Statistics in the US.

And let’s not forget tariffs, which, despite settling into a clearer picture over the course of the third quarter, continue to overshadow projections for global trade.

Indeed, rather than concern the equity market, the multiple global tensions appear to be weighing more heavily on government bond markets where long-end yields have generally increased over the past three months. The cost of government debt and its implications for fiscal policy can be indirectly linked to the resignations of prime ministers in Japan and France (twice), while uncertainty over budget deficits and debt-to-GDP levels is increasing, leading to political tensions in most countries in the G7. However, bond markets remain functional, and there is little sense of genuine panic about levels of borrowing.

Markets are, it appears, waiting for a good enough reason to crack. Grumbles, uncertainty, and political difficulties are not sufficient to offset positive data on corporate earnings and investment. The biggest potential risk is the reliance of larger US tech companies on AI productivity gains. Levels of capital expenditure (capex) on 'compute' – often shorthand for building data centres and filling them with Nvidia graphics processing units (GPUs) – continue to dominate the spending of many of the largest companies in the S&P 500 (with the exception, of course, of Nvidia, which relies on this capex for much of its business). One troubling development towards the end of the third quarter was the circularity of investment in this corner of the tech sector, with Nvidia and OpenAI investing in firms that use their chips and software, respectively.

Another is the open question of the source of power generation required to power these planned data centres, with OpenAI's planned 250 gigawatts of capacity by 2033 equivalent to around one-third of US peak energy demand. However, valuations keep rising and the productivity gains and revenues that might justify the enormous level of capex are, so we are led to believe, just around the next corner. So far investors are giving the AI sector the benefit of the doubt, but there is a sense in markets that patience is starting to wear thin.

2. Our Outlook

Hedge fund performance across most strategies has been strong in 2025¹, with good excess returns over cash and strong alpha generation. Particular bright spots include Discretionary Macro, Equity Market Neutral and Convertible Arbitrage. A notable outlier is Systematic Macro, which has suffered a difficult year, with large losses incurred around the so-called Liberation Day period in April.

Looking ahead, we have a positive stance on Discretionary Macro, Micro Quantitative and Convertible Arbitrage, and are negative on Distressed strategies in Credit. We have a neutral stance on all other strategies but are gently leaning into potential opportunities in Systematic Macro given the difficult recent performance. We are also expressing a degree of caution in Equity Market Neutral and Merger Arbitrage, given the increasing crowding in these strategies.

Figure 1 summarises our stance on different hedge-fund strategies for Q4 2025. Note that we have changed the labelling of this table slightly versus the previous quarter. We have split the previously labelled 'Quantitative' strategies into different categories to better align those strategies with peers. This means that 'Micro Quantitative' now falls within the 'Equity' area (previously labelled 'Equity Long/Short') and 'Macro Quantitative' now falls within Macro, alongside Discretionary Macro, which has been relabelled from 'Global Macro' to better distinguish it from quant strategies.

Figure 1. Q4 2025 Outlook versus Q3 2025 Outlook

3. The Details

3.1 Equity Long/Short (ELS)

We are maintaining a neutral outlook for both low net/market neutral and long-biased traditional equity long/short. Market neutral equity long/short has performed well over the last few years, and we are mindful of crowding in this space as it attracts capital. We continue to watch closely for signs of fragility in larger hedge fund platforms but note with some comfort that periods of deleveraging seen in 2025 have not led to material systemic concerns in other strategies. Overall, we continue to believe that a diversified portfolio of equity specialists may offer an attractive value proposition.

Opportunities:

• Disparate economic policies and deglobalisation may help sustain dispersion at the country and/or sector level
• While rates are expected to fall in certain countries, the path should be measured. Weak companies are still vulnerable in a falling rate environment
• Markets may have reacted to tariff risk early and at the macro level, but the impacts will likely take longer to flow through to corporate earnings and impact fundamentals
• While there remain several thematic trends at play, some have started to broaden out in nature and reduced concentration is a tailwind for active management
• Earnings misses have led to sharper stock price moves than beats, a potential tailwind for short alpha

Risks:

• The crowding factor has done well as of late (crowded longs and shorts have out/underperformed) and this is leading to heightened susceptibility to unwinds
• Heightened net exposure levels have led to beta being a significant component of ELS returns year-to-date
• Political turmoil and economic question marks leave equity markets – which at least in some areas are extremely elevated – susceptible to corrections
• Investors are placing a heightened premium on the impact of AI, and productivity gains relative to heavy spending could ultimately disappoint

3.2 Credit

We have taken a nuanced view on Credit at this point in the cycle. We have upgraded our outlook on Convertible Arbitrage to positive, reflecting the higher issuance of convertible bonds and the desire to be focused on relative value approaches in Credit right now, while maintaining our neutral stance on Credit Long/Short and Structure Credit, and our negative stance on Distressed assets.

Opportunities:

• We expect issuance in convertible bonds to remain high, especially in the US and tech sectors. Historical analysis suggests that higher issuance periods correlate with higher returns to convertible bond arbitrage
• Furthermore, issuance in convertible bonds from firms related to the cryptocurrency industry is growing quickly. These securities tend to exhibit higher levels of volatility and higher levels of retail ownership. Managers who trade Convertible Arbitrage strategies tell us that they are seeing more alpha in trading opportunities around these securities, due to both of these factors, though these same characteristics also introduce significant investment risks
• Elsewhere in Credit strategies, markets remain calm despite pockets of equity market volatility, and the expected path for interest rates is lower in most developed economies

Risks:

• Credit spreads are now tighter than at the start of the year, and close to historically tight levels for both Investment Grade and High Yield. Directional strategies now face an unfavourable risk/reward trade-off across a diversified portfolio
• A period of economic slowdown may lead to rising defaults and lower recovery rates
• Active credit strategies have enjoyed strong returns over the last five years and therefore have been well-subscribed by investors in both public and private markets. As with equity strategies, the risk of crowding in popular trades is increasing, leading to concentration risks as well as lower expected returns

3.3 Event Driven

We are maintaining a neutral outlook for both Merger Arbitrage and Special Situations strategies in the fourth quarter. However, we note that our appetite for Merger Arbitrage, in particular, is increasing on the back of a less aggressive antitrust environment and the fact that tariff noise is now firmly in the market and doesn’t appear to hold back M&A activity any longer. One note of caution, as with other strategies, is that the level of capital chasing Merger Arbitrage has increased, and as such spreads are tighter and the average risk/reward across all deals (as measured by expected profit if all deals close versus expected loss if all deals break) is less attractive than long-term averages.

Opportunities:

• M&A activity has increased by around 30% year-on-year, with activity shifting to large cap deals (when comparing the first half of 2025 to the first half of 2024)
• Tariff uncertainty has now been digested, and US CEO confidence measures have largely stabilised
• There is a less aggressive antitrust environment under President Trump, and the US is more transactional and remedy-oriented, especially with respect to domestic corporate events
• There has been an ongoing positive trend of activist campaigns in the US, with 2025 on track to exceed the already high levels seen in 2022 to 2024
• Managers are increasingly looking at corporate activity in Europe, as priorities have begun to differ between the US and the rest of the world
• Intra-market dynamics in US equities remain interesting for Volatility Arbitrage strategies. One notable divergence has been the difference in index option skew between the S&P 500 and the Russell 2000

Risks:

• Merger Arbitrage spreads have continued to tighten as capital flows into the space and confidence around the deal making environment has improved. Measures of risk/reward are now lower than long-term averages
• Cross-border M&A activity continues to face national protectionism, most notably from the US
• Broader backdrop of geopolitical uncertainty increases the risk of significant market events, during which periods of liquidity withdrawal from markets and strategies typically leads to outsized short-term losses for Relative Value strategies

3.4 Macro

We have a positive outlook for Discretionary Macro and are maintaining our neutral stance on Systematic Macro. On the discretionary side, we expect geopolitical uncertainty to continue, with opportunities arising from dislocation across asset classes and from divergent economic performance between countries/regions. In Systematic Macro, we are keen not to be driven by recent performance and note that assets have generally left the space and that correlations between Systematic Macro strategies have been decreasing. Being contrarian is often a difficult position to take in hedge fund allocations, but we softened our view on Systematic Macro significantly over the last couple of years and are now beginning to look for opportunities to step back into the space as others are potentially departing.

Opportunities:

• Macroeconomic data remains crucial for market developments, with the impact of Trump’s policies becoming increasingly evident. Discretionary strategies may find opportunities in bifurcated economic performance and distinct policy responses
• We continue to like Emerging Markets, though we note that rising popularity and a more beta-driven opportunity set poses risks to these strategies
• We see a growing opportunity set in Fixed Income Relative Value, with potential for bond curve dislocations amid central bank divergence, evolving supply/demand dynamics and shifts in the regulatory backdrop
• In the systematic space, we note that both investors and practitioners are taking a closer look at the role and efficacy of trend-following signals and expect that this will lead to more interesting approaches emerging from this period of difficulty

Risks:

• On the discretionary side, we note with caution that markets seem increasingly resilient to shocks, and that unusual political behaviour tends not to lead to as much widespread asset volatility as previously
• This ‘new normal’ may see investors looking through short-term noise, which reduces the opportunity set for faster moving Macro managers
• The biggest risk to systematic strategies is business stability in the face of client outflows following poor performance. We are keen to ensure that firms are focusing their efforts on improving the investment side of their businesses, rather than exhausting too many resources on retaining clients

^1. Past performance is not indicative of future results.