Hedge Fund Strategy Outlook: Third Quarter 2025

Macro themes we are discussing

Last quarter, we described the investment environment as one defined by elevated economic uncertainty, rising geopolitical tensions, stretched valuations and tight credit spreads. Today, both uncertainty and geopolitical risk have arguably softened a bit. While valuations have gotten more stretched, we are not yet seeing signs of distress—Warren Buffett (retired) is sitting heavily in cash, the Chicago Board Options Exchange's CBOE Volatility Index (VIX) is below 17 and credit markets remain mostly orderly as Wall Street is beginning to offload to retail investors in the private markets.

There are differing views on the drivers of this shift. Some point to the return of US President Trump and the resurgence of market “animal spirits,” others to a broader reordering of the global system as described by Ray Dalio, and still others to the mounting burden of global debt. Regardless of the cause, we anticipate continued market volatility and dispersion, sporadic liquidity during unexpected news events, Trump tweets and the potential for positioning flows to drive markets.

For hedge fund investors and managers, this environment presents both meaningful opportunity and heightened risk. The tails to both the upside and downside are expected to be fatter than previously experienced over the last five years. We expect to see greater divergence in manager performance—even within the same sector—driven by increased volatility. In our view, success in this environment will require portfolios that are diversified, liquid, opportunistic and patient.

Q3 2025 outlook: Strategy highlights

Commodities

Commodities are often quick to react to major macro events, and this has been especially evident this year with oil price volatility around the US tariff announcements in April and the Israel-Iran conflict in June. Bursts of volatility, most notably when driven by an unexpected catalyst, can be a risk to trading strategies, but they are often also a source of opportunity as news is digested and interpreted over time. Large price dislocations are often accompanied by temporary shifts within commodity term structures or across different related commodities. Should macro headlines continue to create these types of dislocations, commodity-focused hedge funds may be able to identify attractive relative value and directional trading opportunities.

Exhibit 1: Oil Prices Have Trended Lower with Volatility in 2025

Price of Brent Crude Oil
December 31, 2024 to June 30, 2025

Source: Bloomberg. Important data provider notices and terms available at www.franklintempletondatasources.com.

Discretionary global macro

The US dollar has trended weaker in recent months, driven lower by a combination of factors related to domestic and international policies, as well as a broad reassessment of popular US exceptionalism narratives. Some currencies, like the Taiwanese dollar, have seen dramatic moves as foreign investors rethink their FX hedging policies or future portfolio allocation decisions. To the extent that this weaker dollar trend persists, macro managers may find opportunities not just in currency momentum but also across developed and emerging markets as well as other asset classes. As with any significant move in major macro markets, there could be risks and opportunities around dislocations or unexpected outcomes—a potentially rich environment for macro-driven traders and investors.

Exhibit 2: The US Dollar Has Weakened Vs. Foreign Currencies

DXY Index Return
December 31, 2022 to June 26, 2025

Source: Bloomberg. The DXY index measures the value of the US dollar against a basket of foreign currencies. Important data provider notices and terms available at www.franklintempletondatasources.com.

International long/short equity

We are in a market environment increasingly driven by macro events, including geopolitical tensions, trade policy shifts, divergent fiscal and monetary paths and inflation concerns. These dynamics contribute to greater dispersion, especially outside of the United States, where geopolitical realignments and divergent monetary policies result in shifting flows. While concerns over US equity valuations and waning US exceptionalism are leading flows abroad—creating a beta tailwind for international long/short equity strategies—the more compelling case lies in the alpha opportunity. Dispersion is being fueled by correlation breakdowns, divergent tariff sensitivities, sectoral realignments and disparate fiscal responses. As global capital is reallocated, flows should not only reflect market sentiment but should also actively drive dispersion, creating alpha opportunities. International markets, shaped by uncertainty and surprises, offer fertile ground for skilled managers to capture alpha through active positioning in a fragmented global landscape.

Exhibit 3: Europe and Asia Equity Net Flows

July 31, 2024 to June 30, 2025

Source: Bloomberg. Important data provider notices and terms available at www.franklintempletondatasources.com.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results. Some subadvisors may have little or no experience managing the assets of a registered investment company. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Derivative instruments can be illiquid, may disproportionately increase losses, and have a potentially large impact on performance.

Equity securities are subject to price fluctuation and possible loss of principal.

Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Currency management strategies could result in losses to the fund if currencies do not perform as expected.

Commodity-related investments are subject to additional risks such as commodity index volatility, investor speculation, interest rates, weather, tax and regulatory developments. Short selling is a speculative strategy. Unlike the possible loss on a security that is purchased, there is no limit on the amount of loss on an appreciating security that is sold short. Investments in companies engaged in mergers, reorganizations or liquidations also involve special risks as pending deals may not be completed on time or on favorable terms. Liquidity risk exists when securities or other investments become more difficult to sell, or are unable to be sold, at the price at which they have been valued.

Active management does not ensure gains or protect against market declines.

WF: 6122277

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