Valuations do not matter! Until they do! Stocks remain a paradox. Flows, positioning, liquidity and momentum are the drivers of this risk-on environment. Both returns and risks have risen, which we see as a great environment for active hedged managers.
Strategy highlights
- Discretionary macro: The market continues to appear macro-driven, with central bank policy changes and divergences taking a lead role in asset-class returns.
- Event-driven: Expectations for a continued busy corporate activity calendar are contributing to a favorable outlook for more directional and opportunistic event-driven strategies, including activism and special situations investing.
- Commodities: A normalization of commodity relationships as markets continue to recover from recent geopolitical and trade policy-led volatility can be a tailwind for active managers.
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Strategy |
Outlook |
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Long/short equity |
Our outlook for long/short equity remains neutral as valuations have increased and geopolitical and macro risks are elevated. Select international markets continue to look attractive. Increased breadth and valuations in the United States suggest a constructive environment for market-neutral funds. Higher dispersion due to artificial intelligence (AI) trends, goods inflation, and re-industrialization portends a favorable trading environment, in our view. |
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Relative value |
The outlook is mixed. Some strategies are benefiting from greater potential dispersion and the possibility of elevated volatility across fixed income markets, while others are suffering from lower risk premia and stretched valuations in asset classes such as convertible bonds. |
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Event-driven |
We maintain a neutral outlook with a favorable view toward activism and special situations investing, and a muted outlook for traditional merger arbitrage, where generally low implied deal spreads have offset strong deal volumes. |
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Credit |
We continue to maintain an underweight stance given historically tight spreads and an oversupply of capital, with a preference for active, idiosyncratic and long/short credit opportunities as a way to capitalize on potential future volatility or buying dislocations. |
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Global macro |
The outlook appears positive as central banks implement policy changes, with some divergences between regional centers. We continue to favor discretionary managers who focus on these shifts, including emerging market specialists, who may benefit from policy tailwinds. |
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Commodities |
Our outlook is positive, especially for relative value approaches, as commodity relationships and price moves recover from recent bouts of volatility. Fundamental supply and demand factors can become increasingly important as macro policy paths become well understood. |
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Insurance-linked securities (ILS) |
We have seen a benign season leading to marginally lower pricing for catastrophe risk, but the asset class remains attractive to us from an absolute yield and portfolio diversification perspective. |
Macro themes we are discussing
The investment environment remains defined by elevated economic uncertainty, heightened geopolitical risks, stretched valuations and tight credit spreads. While risk perceptions have shifted at the margin—valuations more demanding, credit spreads tight—the system does not yet appear distressed. Volatility remains contained (VIX < 171), and liquidity ample as central banks are now cutting rates, providing more liquidity to the global system.
Opinions differ on the drivers: the return of US President Trump and revived “animal spirits,” hedge fund manager Ray Dalio’s long-term global reordering, or unsustainable debt burdens. Regardless, we expect volatility, dispersion and sporadic liquidity gaps/bursts to persist, with positioning flows and crowded trades amplifying swings.
For hedge funds, this backdrop presents both opportunity and risk. Fatter upside and downside tails are likely, with greater divergence in manager performance. We believe success will depend on portfolios that are diversified, liquid, and flexible.
In short, dynamic and opportunistic hedge fund strategies look well positioned to take advantage of dislocations, provided they remain disciplined, selective and nimble.
Q4 2025 outlook: Strategy highlights
Discretionary macro
Macro managers can do well when policy paths change or diverge between regions. In the most recent period, the Federal Reserve (Fed) seems to have lagged the European Central Bank’s (ECB’s) cutting cycle, while the Bank of Japan (BoJ) has moved in the opposite direction with periodic rate hikes. As fiscal announcements have shifted to implementation phases, and as macro data begins reflecting those new agendas, monetary policymakers may have higher confidence in their forecasts and more willingness to implement changes themselves. These policy changes can be a rich source of opportunity for discretionary macro managers, with primary and secondary effects typically playing out across asset classes and regions.
Exhibit 1: Fed, ECB and BoJ Policy Rates
Managers Can Benefit from Active Central Banks, Especially When There Are Regional Divergences
January 2000–September 2025
Source: Bloomberg. As of September 2025. Important data provider notices and terms available at www.franklintempletondatasources.com.
Event-driven
We have observed a notable pickup in corporate activity, including more complex situations including activist campaigns, sponsor-backed and take-private mergers and acquisitions (M&A), and corporate separations such as spinoffs and carve-outs. Unlike traditional merger arbitrage strategies, which primarily capitalize on the deal spread of announced M&A, generalist event-driven managers have a broader toolset to capitalize on the diverse set of corporate actions. We expect the busy pipeline of corporate events to continue, offering a more robust opportunity set for managers specializing in activist and special situations strategies.
Exhibit 2: Number of Public Activist Campaigns
2025 Tracking Toward Record Levels of Activism
January 2016–August 2025
Source: Citi North America M&A Review. As of September 2025. Important data provider notices and terms available at www.franklintempletondatasources.com.
Commodities
Managers specializing in a single asset class or sector often view bouts of market volatility as more of a source of risk than opportunity, especially when exogenous or macro events create that volatility. As markets digest the outside news, those same managers often find the most attractive trading opportunities. In 2025, commodity markets had two major exogenous shocks—the first around US tariff announcements in April, and the second around a flare-up of Middle East tensions in June. As the initial shock has worn off, investors appear to have shifted their focus to the fundamental implications of these events and realized volatility has decreased. For commodity specialists trying to identify supply and demand imbalances, this shift toward market fundamentals could help improve the alpha opportunity set.
Exhibit 3: Realized Volatility of Bloomberg Commodity Index
Commodity Volatility Has Declined after a Macro-Driven Spike Earlier in the Year
December 2022–September 2025
Source: Bloomberg. As of September 2025. Important data provider notices and terms available at www.franklintempletondatasources.com.
Endnote
- CBOE Market Volatility Index (VIX). Often called the "fear gauge," the VIX measures the market's expectation of 30-day volatility based on S&P 500 index options.
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: 6934712