FRM Early View - February 2017
- Hedge fund returns continue to recover from a difficult 2016, with Managed Futures strategies leading the way in February
- Equity and Government Bond markets seem to be pricing different levels of political risk in both Europe and the U.S.
- Managers remain cautiously optimistic about the ability to generate alpha in 2017
February broadly supported our view that 2017 would be a better year for hedge fund alpha. The thesis remains that the new divergence of monetary policy in developed markets will drive price adjustments across all asset classes in a way that could prove more susceptible to traditional valuation techniques than wholesale global quantitative easing, which helps both stock picking and portfolio construction. The risk free rate of return is the place to start: since the U.S. election, U.S. two year yields have risen by about the same amount as German two year yields have fallen, driving the spread by a massive 60 basis points in four months. So far, so consistent. But from hereon in, we believe that the argumentative going gets much tougher.
To start, buyers appear to be queuing for a real yield of -2.4% in Germany. European growth is surprising on the upside, German inflation is at 1.5%, but German two year yields in the last six weeks have fallen about 30 basis points (three quarters of the move they made over the entirety of 2016).
Of course political uncertainty in France, Italy, Greece, the Netherlands and Germany is an important factor: to look at the 2% spread between 10yr yields on German and Italian Bonds reached in February (fully 40% of the spread seen in the European debt crisis of 2011) there appears to be trouble afoot. But European Equities are not looking at this spread: they are up a solid 1% this year (as compared with a peak-to-trough drawdown in 2011 of 35%).
It is not that anyone thinks a win for Le Pen is good for Equities in the way that Brexit was good for the FTSE 100 Index or that Trump might be good for U.S. Equities. Nor do gamblers think a Le Pen win that improbable: as of 27 February, the internet betting exchange Betfair have the chance of a Le Pen victory at about one in four which, two months out, puts it on a par with Brexit or Trump. But if hedge fund managers (as opposed, that is, to mere gamblers) are to be believed, the answer to the Equity conundrum is in the polls, not the betting shops this time: the head-to-head polls between Macron and Le Pen put a likely second round vote at around 65%/35%, as compared with Clinton and Trump of 48%/45%. So the point is that there needs to be a substantially larger polling error than anything we saw in 2016 to deliver a Le Pen victory at this stage.
Indeed one could go further and say that the Greeks may push their issues further down the road, the Dutch Freedom Party may win a majority of seats and still fail to form a government, and the Italian situation will remain muddled without slipping into crisis. In short, however doomed Europe may be in the long term, the odds on imminent collapse are always far too long. So in this view, even though we started by saying that Bond yields are to be transparent drivers of all asset classes this year, we are troubled by both the absolute level of yields in Europe and the spreads between them, preferring instead to go with the Equity markets.
The Bond/Equity connection also seems problematic in the U.S. at the moment. 10 Year Treasuries rallied on the month, suggesting a weaker inflation outlook, which with reasonably full employment probably points to lower growth too. But Equities, again, aren’t looking at Bonds (they don’t even read the newspapers replete with irregular dealings with Russia). They are up anywhere between 5% and 10% and as stately as a Spanish galleon. It is not as if U.S. Equities were particularly cheap to begin with, and Q1 corporate earnings upgrades in the U.S. have been weaker than in Europe or Asia. The heart is with the signal coming from the Bonds. The head tells us to spare you a reprise of our views on post-truth politics and admit confusion. We’ll go with the head.
With so much of the resolution of Bond/Equity pricing in the hands of politicians (the least predictable of drivers, as we have been recently reminded), we are all wondering too about volatility in risk assets – or at least the lack of it. If you can’t guess successive moves, you either chase the markets or you do nothing (which appears to be the prevailing preference). But they are both reasonable reactions to the same problem, which is why low volatility is so often followed by high volatility with relatively little in between. Of course if you want to systematically chase markets, CTAs do it for a living… and a very good living they made of it in February.
Historically consistent with low volatility, Emerging Markets have also seen a robust start to the year, with the second largest inflow into EM funds over the year to 22 February since 2004 (source: Morgan Stanley). Here the markets appear to be backing Trump’s infrastructure spending and weak USD policy talk rather than his talk about global trade. As with volatility, this could change fast.
Where does this all leave us on hedge fund alpha? Well, these discussions often feel a bit slippery. That’s partly because they are so often linked to marketing. But it may also be because in some articulations, alpha is the bit of the investment return that is, by definition, harder to explain. So with this lightning discussion of macro inconsistencies, we should hardly expect at one blow to explain the performance of so many smart managers doing idiosyncratic things. But the point we do want to make is that, for hedge funds, the very idea of this type of reasoning about inconsistencies implies that rational valuation in at least some major markets is back on the table this year.
Hedge funds enjoyed broadly positive performance in February as Credit and Equity managers benefited from rising markets, and Relative Value strategies continued to see a recovery from the difficulties experienced in 2016. Managed Futures managers also had a good month as they are currently long both Equities and Government Bonds.
In Equity Long-Short, managers with any kind of net exposure benefited from beta as Equity markets rallied on the month, but the alpha picture was mixed. In particular, some European managers noted that there were short periods of very negative alpha early in the month, which may have been driven by active managers removing risk from the markets ahead of the many political events of the next few months.
Equities have also been the main source of gains this month for Managed Futures managers, with long positions across all regions contributing. The U.S. has been the primary source, closely followed by European positions. FX and Fixed Income were minor positive contributors, while Commodities was a detractor.
In terms of positioning, we believe that the biggest area of risk for Managed Futures managers remains Equities where managers continue to be net long across the board, particularly so in North America and Europe. FX is the second largest area of risk, with net long positions in AUD and CAD, and net short positions in EUR, GBP, and JPY – the net long USD bias has shrunk over the first two months of the year. In Rates, the managers have no clear view with a net paid bias in the U.S. and a net receive bias in Germany. In Commodities, managers are net long all sectors.
Corporate Credit managers (Credit Long-Short and Credit Value) generally posted another month of positive returns in February driven primarily by idiosyncratic positions (e.g. financial preferred securities did well again, recently emerged post-reorg. energy sector Equities, some municipal debt positions, etc.).
Lower-rated U.S. high yield Credits outperformed higher quality names for another month. Most U.S. high yield sectors were positive for the month with the Healthcare sector outperformance driven by positive earnings surprise from a leading operator of hospitals in the U.S. The Retail sector continued its underperformance in February driven by more negative news out of the sector. Primary market activity and fund flows, especially for U.S. leveraged loans, remained fairly robust in the month after a notable January.
Returns were also mostly positive for Structured Credit managers, primarily driven by carry with small mark-to-market gains across most sectors with the exception of some post-crisis vintage commercial mortgage-backed securities (‘CMBS’). Some of the lower-rated tranches of the synthetic post-crisis vintage CMBS indices saw a very steep selloff in the month among increasing worries about the retail exposure in these deals.
In Relative Value strategies, February was another solid month for Statistical Arbitrage managers, with strategies across all major strategy types ending the month positive. The start of the month was a continuation of the favourable environment in January, with stable factor performance and minor persistent positive returns to technical strategies. The second half of the month was much more muted in comparison, with most strategies flat since mid-month. Fundamental strategies continued their positive start to the year, with factor volatility remaining lower than it had been for much of 2016, and the range of performance relatively constrained. Europe was again a noteworthy region for the strategy, with Asia mixed, and the U.S. the weakest. Technical managers also generated robust returns (though we have less colour on the drivers) and fast futures strategies were also positive – and anyone trading momentum in futures had a notable month in line with the Managed Futures performance.
As it relates to corporate activity and the opportunity set for Event hedge funds, the markets are awash with both optimism for a deregulatory policy bent in the U.S. and uncertainty on timing and ultimate outcomes on major policy initiatives such as tax reform. Special Situations, Event Equities, and Relative Value trades have led the charge in January’s supportive markets, while it has been a more mixed month for spreads, with some deals adding, and others detracting.
Deal flow month to date ($321bn) included a hefty $198bn of “proposed” deals. Notable signed deals included Mead Johnson/ Reckitt Benckiser ($17bn cash) and the master limited partnership deal of ONEOK Partners/ONEOK ($9bn stock). The dramatic proposed, and then withdrawn, Unilever/Kraft Heinz deal dominated the headlines. News and speculation also surrounded Bristol-Myers (amid activist activity) and Macy’s.
Discretionary Macro performance was mixed in February, with several managers tactically reducing risk, particularly in FX, and varied contributions across sectors. The reflation theme continues to be a focus for Macro managers, though break-evens tightened slightly on the month and nominal yields rallied across all regions. Gold has also exhibited a robust rebound of +9% year to date – some managers have continued to maintain long gold positions citing concerns about the long term stability prospects of fiat currencies. EM exhibited another positive month supported by year to date inflows of more than $10bn into EM-dedicated funds – EM FX crosses and EM Equities broadly rallied, and Macro managers benefited with bullish positions held across EM FX, Equities, and Credit.
Within FX, managers have reduced some of their long USD exposures, but still maintain meaningful shorts versus EUR and JPY on the expectation of underperformance from low yielding currencies in a hawkish U.S. Federal Reserve environment. Several managers benefited from bullish EM FX positions, including long BRL and RUB. The reflation theme has also motivated long USD versus Asia FX trades, as within the Asia region managers have argued that reflation is more closely linked to the Commodity cycle than core Asia inflation metrics. Also, protectionism threats should be near-term USD-positive.
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