Hedge Fund Strategy Outlook: Fourth Quarter 2026

Strategy Highlights

1. Equity market neutral: The combination of elevated single-stock dispersion, muted index level volatility, low correlations and strong corporate fundamentals favor strategies that isolate alpha over relying on beta.
2. Credit: Weakness in certain parts of the credit markets serves as a sign of potential fragility, as the environment faces challenges from rising rates and record new debt issuance to finance capital expenditure (capex) growth.
3. Commodities: Macro forces continue to play out across commodity markets, creating both relative value and directional opportunities for active specialists, though exogenous tail risks remain elevated.

Macro Themes We Are Discussing

1. Resilience persists, but beneath the surface divergence is growing

Economic and corporate fundamentals have proven more resilient than many investors expected, supporting risk assets despite a year characterized by considerable policy and geopolitical uncertainty. Corporate earnings remain an important source of support, while recent internal analysis has highlighted improving breadth in earnings revisions rather than strength being confined exclusively to a narrow group of companies.

However, resilience at the aggregate level increasingly masks differentiation beneath the surface. Growth, profitability, balance-sheet quality, financing costs and consumer sensitivity vary meaningfully across companies and industries. We believe these differences matter more as investors become increasingly discriminating about the durability and quality of earnings. A resilient economy therefore does not necessarily imply uniform investment outcomes.

For hedge funds, this is an important distinction. Markets do not need to become broadly bearish for alpha opportunities to improve. An environment characterized by continued economic growth alongside widening fundamental differentiation can be particularly favorable for managers whose returns are driven more by security selection than market direction.

2. AI is evolving from a thematic trade into a capital-allocation test

AI remains one of the most important secular drivers of corporate investment and market leadership. Earlier in the year, AI-related spending helped reinforce earnings expectations and supported a broad ecosystem extending beyond technology into semiconductors, infrastructure, power and other capital-intensive industries. The more important question looking forward, however, may increasingly be whether the scale of investment produces sufficient economic returns.

As capital commitments expand, we expect greater differentiation between companies that successfully translate AI investment into productivity, revenue growth, or durable competitive advantage and those for which spending proves less productive. Internal investment discussions increasingly reflect both sides of this dynamic, highlighting strong earnings associated with the AI cycle while also monitoring financing conditions, capital spending, free cash flow, and the risks associated with AI-related investment.

We therefore increasingly view AI not simply as a directional investment theme, but as a potential source of fundamental dispersion. The transition from enthusiasm toward greater scrutiny of returns on invested capital should create opportunities on both sides of portfolios. For long/short and relative-value managers in particular, the ultimate winners and losers from the AI investment cycle may matter considerably more than the direction of the theme itself.

3. Dispersion, rather than outright volatility, may define the opportunity set

Headline volatility remains an important component of the hedge fund opportunity set, but we believe dispersion is becoming an equally important consideration. Broad indexes can remain stable even while individual securities, sectors, industries and geographies experience different fundamental and market outcomes.

This distinction is increasingly visible within equity markets. Internal investment discussions have specifically identified the unusually wide relationship between single-stock and index option volatility as evidence of strong equity dispersion and an attractive environment for dispersion-oriented strategies.

For active managers, this means attractive opportunities do not necessarily require a sustained increase in broad-market volatility. Greater differentiation among securities can create opportunities to build portfolios around relative winners and losers while limiting dependence on market direction. We believe this environment is particularly constructive for long/short equity and market-neutral approaches, as well as relative-value strategies capable of exploiting differences across securities and capital structures.

4. Policy and geopolitical uncertainty are reshaping relationships across markets

Policy uncertainty has not disappeared, but its composition continues to evolve. Monetary policy remains important, yet investors must simultaneously consider fiscal policy, tariffs and trade policy, government financing needs and ongoing geopolitical developments. Recent internal discussions have highlighted these dynamics alongside changing assessments of inflation, tariffs, government bonds and the diversification benefits of duration.

The consequence, in our view, is not simply greater event risk. It is a less stable relationship between asset classes and economic variables. Traditional assumptions regarding the interaction among equities, rates, currencies and commodities may become less dependable when inflation, fiscal policy, trade and geopolitics exert competing influences on markets.

This creates risks for static portfolios but potential opportunities for flexible managers. Global macro and relative-value strategies can benefit from changing policy expectations, cross-country divergence, and repricing across rates, currencies and commodities. We expect episodic policy and geopolitical developments to remain important sources of both volatility and relative-value opportunities.

5. Complexity favors active management: alpha over beta remains our central conviction

Taken together, these dynamics reinforce a theme that has shaped our outlook throughout 2026: The opportunity set increasingly favors flexibility, selectivity and active risk management. The case for hedge funds does not depend on forecasting a recession, a bear market, or a persistent volatility shock. Instead, it rests increasingly on the complexity developing underneath relatively resilient financial markets.

That complexity is visible in widening fundamental outcomes, changing market correlations, increasingly consequential capital-allocation decisions, and the interaction among monetary, fiscal, trade and geopolitical forces. These conditions can produce periodic dislocations and create opportunities for managers capable of dynamically adjusting exposures, identifying relative value and managing downside risk.

Accordingly, alpha over beta remains our central conviction. We continue to favor strategies in which returns are driven primarily by security selection, relative-value positioning and tactical flexibility rather than sustained directional market exposure. As we enter the final quarter of 2026, we believe the ability to distinguish between winners and losers, rather than simply determine whether markets move higher or lower, will remain one of the most important sources of opportunity for hedge-fund investors.

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.

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GLOSSARY

Alpha: A measure of an investment’s return above or below what would be expected based on its exposure to a benchmark or market. Often used to assess the value added by active management beyond returns attributable to market exposure.

Catastrophe (cat) bonds: A type of insurance-linked security designed to provide insurers and reinsurers with financial protection against losses from major disasters (i.e., hurricanes, earthquakes, floods or other large-scale catastrophes).

CBOE S&P 500 Dispersion Index (DSPX): Measures the market’s expected dispersion over the next 30 days, or the degree to which S&P 500 constituent stocks are expected to move independently of one another, derived from S&P 500 Index and single-stock option prices using a modified VIX methodology.

CBOE Market Volatility Index (VIX): Measures market expectations of near-term volatility conveyed by S&P 500 Index option prices. Often called the “fear gauge,” lower readings suggest expectations for lower market volatility, while higher readings suggest expectations for higher market volatility.

Convertible arbitrage: A hedge fund investment strategy that seeks to profit from pricing differences between a company’s convertible securities (usually convertible bonds) and its common stock.

Correlation: A measure of the relationship between an investment’s returns and those of a comparison index. The correlation coefficient, expressed as a value between +1 and –1, indicates the strength and direction of the linear relationship between the investment’s returns and the returns of the index.

Directional: An investment strategy where a trader or fund takes positions based on a view that the price of an asset or market will move up or down.

Discretionary: Refers to an investment approach where portfolio managers make investment decisions based on their own analysis, judgment, and interpretation of fundamental, economic, political, and market developments.

Leveraged buyout (LBO): An LBO is the acquisition of a company using a significant amount of borrowed money, typically with the acquired company’s cash flows and assets used to support repayment of the debt.

Magnificent Seven: Refers to shares of Apple, Microsoft, Amazon, Alphabet, Meta Platforms, Nvidia, and Tesla.

Merger arbitrage: An investment strategy that seeks to profit from the price difference between a target company’s current stock price and the price offered in a proposed merger or acquisition.

Relative value: Relative value is method of determining an asset’s value that takes into account the value of other assets. In contrast, absolute value looks only at an asset’s intrinsic value and does not compare it to other assets.

Special situations: An investment strategy that seeks to profit from corporate events or extraordinary circumstances that can affect a company’s value.

Systematic: An investment approach that uses quantitative models, algorithms, and predefined rules to identify and execute trading opportunities across markets.

Volatility arbitrage: A trading strategy that aims to profit from differences between the implied volatility of an asset (as reflected in option prices) and the trader’s estimate of its actual or future realized volatility.

Spread: The difference between two related prices, yields, or values. In credit markets, the term spread generally refers to the difference in yield between a bond and a comparable benchmark, typically a government bond or other reference rate. A “tight” spread indicates a relatively small difference, while a “wide” spread indicates a relatively large difference.

Z-score: A statistical measure indicating how many standard deviations a value is above or below the mean (average) of a group of values. A Z-score of 0 indicates that the value is equal to the mean.

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.

An investment in private market investments is suitable only for investors who can bear the risks associated with them (such as private credit and private equity) with potential limited liquidity. Shares will not be listed on a public exchange, and no secondary market is expected to develop.

Important Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

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