FRM Early View - March 2017
- Hedge funds generated positive returns on average during March, with Equity Long-Short and EM focused strategies leading the way
- Political risks remain focused on the French election and the ability of Trump to enact the growth-friendly elements of his agenda
- Looking forward, we believe markets will continue to exhibit higher dispersion than last year, and that this will be good for hedge fund alpha
We believe one of the reasons why hedge funds performed poorly in 2016 was the propensity of events, such as Brexit and Trump, to cause markets to correlate around a single narrative. If the appeal of hedge funds is that they might be able to find multiple uncorrelated sources of idiosyncratic returns that complement an investors’ portfolio of traditional assets, then overly-dominant agenda-setters such as these are bad for generating a broad range of alphas in our view.
We have said a number of times over the past few months that we think the sources of return available to hedge funds in 2017 could be more disperse than in 2016, and therefore we remain confident that hedge funds still have the potential to achieve alpha-driven return profiles that investors seek. Indeed, recent data on dispersion of assets both between and within assets classes suggests to us that the environment has been much better over the past few months (and, incidentally, so do hedge fund returns).
So where might it all go wrong? In the short term, one clear risk to this improved correlation environment is the French election. This risk appeared to recede in March as European Equity markets rallied in response to the result of the Dutch general election. We think that the situations in France and the Netherlands are sufficiently different that there is little read-across from one election to the other, but markets seem to disagree. The poor showing of the populist far-right candidate Geert Wilders (well beaten into second place despite leading the polls only a few weeks before the election) buoyed markets and led to speculation that Marine Le Pen will underperform her polling expectations. We will be watching the first round of voting on 23 April very closely; a result that is anything like the current opinion polls should be a clear bullish signal for Macron, as Le Pen would be unlikely to overcome the current deficit in the second round.
We won’t try to predict how Equity markets would react to a Macron victory since a) a lot is in the price already given the rally in March; and b) we learned last year that markets can sometimes confound everyone in the days following political events. Instead, we think it is a safer bet to say that a Macron victory would help defuse the level of political risk in European Equity markets and potentially lead to greater dispersion of Equities, which (back to our central theme) may be beneficial for hedge funds over the next few months. For what it’s worth, we remain convinced that a shock Le Pen victory would be bad for both markets (especially from these more elevated levels) and hedge fund alpha potential, as correlations would most likely rise again to reflect the uncertainties of political risk.
Turning to the U.S., the Trump situation is harder to read. The mess around the last-minute pulling of the healthcare bill has raised questions about Trump’s ability to enact the more market-friendly elements of his agenda. In our view, the most startling aspect of the situation is how poorly Trump managed to align the disparate strands of the Republican Party, failing to gain support from both those who thought the legislation was too punitive and those who felt it didn’t go far enough. Once again, the differences between the skill set required for corporate deal making and political deal making are becoming clearer.
Following the failure of the healthcare bill, there have been two distinct days of profit-taking by hedge funds in U.S. markets – 21 March and 27 March. On both days, commonly held hedge fund longs sold off and commonly held shorts rallied, leading to significant negative alpha. Our analysis of hedge fund holdings does not suggest that there is any worse crowding of positions now than there has been previously – but days such as these show the risk of a common thesis across the active management community (in this case, the Trump reflation trade).
Here too we believe there is reason for optimism. Our invested managers now have a more diverse set of views on the ability of Trump to enact his agenda. The bulls note that there are still potentially easy wins for Trump on repealing Obama’s executive orders on regulation (which requires relatively little collaborative action); whereas the more sceptical managers believe the frictions within the Republican Party and ongoing investigations into links with Russia represent a material block on the ability of Trump to achieve tax reform. If nothing else, we think that a plurality of views on the efficacy of the Trump administration is a healthier state of affairs for hedge funds than the tight alignment of opinion that followed his election in November.
Outside of Le Pen and Trump, we believe there is a pleasing array of sources of macroeconomic risk and potential opportunity for hedge funds. The U.S. Federal Reserve (“Fed”) is raising Rates while the European Central Bank is increasingly wary of tapering; volatility is returning to the oil price which has led to dispersion in Credit markets as Energy producers come under pressure again; a stronger earnings outlook means there are more corporate winners and losers and M&A activity remains high; Article 50 has finally been triggered by the U.K., and so on. Trading any one of these successfully is rightly difficult (we don’t pay hedge fund fees for nothing), but at least this year there appears to be enough breadth of opportunity for hedge funds to potentially prove their worth.
Hedge funds generated positive returns on average during March, with the best performance generally coming from European focused Equity Long-Short, EM focused Macro strategies and some Relative Value strategies. U.S. focused Equity Long-Short and Credit specialists produced mixed performance, and Managed Futures managers generally saw losses.
In Equity Long-Short, the rally in European markets helped managers with a larger allocation to this region, and unsurprisingly those with higher beta performed better than their market neutral peers. The profit-taking days towards the end of the month hurt managers in all regions despite being driven by concerns over the ability of Trump to deliver more market-friendly reforms in the U.S. Despite mixed performance, we haven’t yet seen any U.S. Equity Long-Short managers with notable negative performance. Asian managers were generally positive as valuation metrics continued to normalize across the region.
Discretionary Macro managers exhibited positive performance overall in March, led by EM focused Macro managers. The resurgence in EM risk markets on the year, with the MSCI EM Index at +12% in Q1 and EM FX Index broadly higher versus the USD, has provided a robust trading environment in both Latin America and Asia ex-Japan, and Macro managers have generally capitalized. Long MXN versus USD was noteworthy as the peso rallied +7% on the month in light of Trump’s more subdued rhetoric on protectionism. Contributions to global growth have been supported by a broad base of fundamental indicators (U.S. domestic demand, wage growth, as well as stronger global trade) which, in our view, suggests that the underlying environment for EM assets remains supportive.
Within developed markets, price action in March was a bit bumpier, with the DXY Dollar Index finishing -1% on the month and U.S. Treasury 10 year Rates trading in a wide 25bps range, peaking ahead of the Federal Open Market Committee (“FOMC”) mid-month meeting, and then rallying to finish the month unchanged. Fed President Yellen delivered a more dovish statement at the March FOMC meeting, which fuelled the U.S. Treasury rally and the tightening of inflation break-evens, and some Macro managers suffered losses from paid U.S. Rates positions. European Rates, on the other hand, were slightly higher, led in the intermediate sectors by German Bunds, and as concerns about the French political situation receded slightly. Many Macro managers benefitted from the outperformance of European Equities over the U.S. during March.
One other recent development in the Macro space worth noting is the significant tightening of the cross-currency basis swap globally, indicating an increase in the availability of global USD liquidity. USD/JPY 3-month basis swap in particular has tightened from 91bps in November to 30bps currently. Recent weekly security flow data from the Japan Ministry of Finance have revealed notable inflows into Japan money market instruments, many of which have then been subsequently swapped back into USD as the prospect of U.S. bank deregulation has helped loosen U.S. bank risk appetites.
In Managed Futures, Equities were the only positive sector in March, with long positions in Europe and Asia gaining the most. FX, Commodities and Fixed Income were all marginal detractors. We believe the biggest area of risk for Managed Futures remains Equities where managers are net long in North America and Europe. FX is the second largest area of risk, with net short positions in JPY, GBP, EUR and CAD1. In Rates, the programmes are close to flat while in Commodities there has been a move to a slight net short bias which has occurred in the latter half of the month.
Corporate Credit was muted with most managers in the peer group posting flat to negative returns for the month. Credit Long-Short managers generally held up better than outright Distressed managers. After a noteworthy 12-month rally for commodity-related Credits, there was some give back in March as crude oil was lower driven by a rise in inventories and increased production. Also, the recent developments in Puerto Rico caused mark-to-market losses across most PR obligations. A long-term fiscal plan was approved in March that indicated smaller debt service capacity than previously anticipated by creditors.
Structured Credit manager returns across the peer group were mixed with minor gains from principal and interest payments. CLO mezzanine debt continued to perform well in March benefitting managers with larger allocations to the sector.
The Event strategy backdrop in the first quarter has included expectations for business-friendly policy initiatives to fuel the corporate activity opportunity set, but March has had a somewhat more mixed tone, with U.S. stocks and High Yield Bonds moving sideways or down as a rapidly developing landscape is shaping expectations. For example, at a high level, the nuts and bolts of healthcare reform in the U.S. took centre stage in March as an indicator of the new administration’s ability to enact policy in such a noisy political environment.
More specific to the environment for deal flow, March reports of Deputy White House Counsel, Makan Delrahim, being nominated to lead the Justice Department Antitrust Division indicates that more clarity on the outlook for antitrust policy should be imminent. Other notable themes have included the role of supportive debt markets in encouraging Private Equity sponsors to deploy considerable cash balances in deals, and the impact of Chinese capital controls in meaningfully reducing the volume of cross-border deals YTD versus 2016.
It was a mixed month for Statistical Arbitrage managers. Fundamental strategies generally did well, while there was much more dispersion in Technical and Futures based strategies. Fundamental strategies had a robust month, especially in Asia where a variety of factors worked particularly well, including both Value and Momentum, which has historically signified a more favourable environment for Quantitative Equity strategies. Europe and the U.S. were slightly more mixed. Futures strategies that have a higher momentum component were negative, but shorter term strategies generally performed better.
1. Based on a peer group of 6 Managed Futures hedge fund managers selected by Man FRM.
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