Hedge Fund Strategy Outlook: First quarter 2026

Preview

Concentration versus diversification is a major question on the minds of many investors as 2026 kicks off. Hedge funds can offer diversification, active management and alpha generation which we believe are valuable tools for investors looking to manage risk and generate differentiated returns.

Health care: The sector has underperformed for three years and trades at a record discount relative to the S&P 500. The regulatory environment has improved on several fronts, innovation is robust, and the merger & acquisition (M&A)/initial public offering (IPO) environment has improved, which we believe is setting up a favorable stock-picking environment.
Merger arbitrage: The record-setting pace of M&A activity looks likely to continue and should contribute to attractive spreads and trading opportunities for active strategy specialists.
Long/short credit: Credit managers who can remain nimble, active and can express their ideas both long and short can look to take advantage of volatility and dispersion.

Strategy	Outlook
Long/Short Equity	Our outlook for long/short equity remains neutral amid still-elevated valuations, increased market crowding, and discussions of excess around artificial intelligence. Equity markets have strong earnings expectations but are tempered by a shallow rate-cut path and macro risks (e.g., labor). We anticipate dispersion to continue to be elevated and benefit lower net strategies emphasizing alpha over beta.
Relative Value	Our outlook is neutral, with marginal improvements at the sub-strategy level for convertible arbitrage (due to strong new issuance) and volatility arbitrage (higher market reactivity to sell-offs). Fixed income arbitrage remains favorable due to expectations for continued volatility and uncertainty in the rates markets.
Event Driven	Our outlook is neutral, with some movement at the sub-strategy level, including a downgrade for activism due to stretched valuations and mixed success rates, and an improvement to merger arbitrage due to strong deal volumes and permissible regulatory regime.
Credit	We 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.
Global Macro	The opportunity set remains attractive, but potentially less obvious now that policy rates have declined and economic trajectories appear increasingly two-sided. We continue to favor discretionary managers who may be better positioned to navigate an uncertain environment by reacting to incoming data and evolving narratives.
Commodities	We remain constructive, continuing to favor managers with experience interpreting macro developments alongside idiosyncratic commodity-level fundamentals. We expect the opportunity set to continue to broaden as exogenous shocks like tariffs and geopolitical shifts become better understood.
Insurance-Linked Securities (ILS)	While compressing yield, robust investor demand continues. Total catastrophe (cat) bonds outstanding issuance has grown to approximately US$60 billion at the end of December 2025, about 20% growth year-over-year (y/y)¹. While the yield has dropped to below 9%, cat bonds remain attractive amid compelling risk-adjusted returns and low correlation.

This outlook is provided to you for informational purposes and is not intended for redistribution. It shall not constitute an offer to sell or a solicitation of an offer to buy an interest in any investment product or fund.

Macro themes we are discussing

As we enter 2026, the macro landscape is defined less by a single dominant narrative and more by the collision of multiple regimes—economic, geopolitical and market‑structural—that are operating on different time horizons. Together they create an environment that is both unusually fluid and unusually path‑dependent.

1. The global cycle is drifting into an asymmetric phase.

Central banks have begun easing, but the global cycle is not synchronizing. The United States remains resilient, Europe has been stabilizing from a low base, and parts of Asia are navigating divergent policy paths. Interest-rate cuts are adding liquidity back into the system, but they are arriving at a moment when valuations—across equities, credit and alternatives—are already demanding. This creates a tension between supportive liquidity and compressed forward returns, with markets increasingly sensitive to incremental macro data.

2. Geopolitical risk is now a structural input, not a tail event.

The return of US President Trump has reset expectations around US trade policy, regulatory positioning and geopolitical posture. Simultaneously, the broader global reordering highlighted by thinkers like Ray Dalio continues to shape supply chains, capital flows and national priorities. These forces raise the probability of episodic dislocations, where geopolitical catalysts interact with crowded positioning to produce outsized price moves.

3. Markets appear calm, but underlying fragilities persist.

Surface‑level volatility remains surprisingly subdued—exemplified by a VIX² consistently below 20—even as dispersion under the surface is expanding. The calm reflects ample liquidity, strong corporate balance sheets, and a market conditioned by years of central‑bank intervention. Yet credit spreads are near historic tights, equity concentration is elevated, and several asset classes are priced for near‑perfection. These conditions leave markets prone to sharp, sentiment‑driven air pockets.

4. Structural leverage and debt burdens are becoming more visible.

Public and private balance sheets alike have benefited from the long arc of declining rates. As the world transitions toward a more normalized rate environment—even with cuts beginning—questions around debt sustainability, refinancing dynamics, and long‑duration cash flows are likely to resurface. Investors will need to differentiate between liquidity‑supported resilience and genuine balance‑sheet strength.

5. What does this mean for hedge funds?

For alternative managers, this is a market shaped by fat tails, evolving liquidity conditions and widening dispersion, both across and within asset classes. It is an environment in which we believe the ability to adapt in real time—through flexible risk budgets, diversified exposures, and disciplined portfolio construction—will determine success. The opportunity set remains rich in our view, but it favors managers who can avoid crowding, exploit volatility bursts, and operate with nimble, unconstrained playbooks.

In essence—2026 does not look like a year for static positioning. It is a year that we think will reward selectivity, agility and diversification, with hedge fund strategies uniquely positioned to extract value from a macro environment where traditional asset classes may offer more limited upside and asymmetric downside risks.

Endnotes

Source: Q4 2025 Catastrophe Bond & ILS Market Report. Artemis. There is no assurance that any estimate, forecast or projection will be realized.
VIX is the ticker symbol and the popular name for the Chicago Board Options Exchange’s CBOE Volatility Index, a popular measure of the stock market’s expectation of 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.

This outlook reflects the opinions of the K2 Investment Management (IM) group as of December 31, 2025, and may not reflect the views of other groups within K2 or Franklin Templeton. The information provided is not a complete analysis of every material fact regarding any country, market, industry, security or fund. Because market and economic conditions are subject to change, comments, opinions and analyses are rendered as of the date of this material and may change without notice. A portfolio manager’s assessment of a particular security, investment or strategy is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy; it is intended only to provide insight into the fund’s portfolio selection process.

WF: 8184318