FRM Early View - November 2018
- The rise in risk free rates, higher ambient volatility and increased stock bond correlation have created a new complex environment
- Equity Long-Short and Credit suffered further losses in November while Discretionary Macro and Merger Arbitrage strategies performed better
- Deleveraging pressure impacted Quantitative Equity and Statistical Arbitrage managers
As that mind numbing decade in which QE was ‘all ye know on earth, and all ye need to know’ turns into history, those of us working with more market neutral alternatives are mostly glad to see the back of it: QE engineered performance from long only assets with which we could not compete and the opportunity for most of us to make a real difference to our investors has been long delayed. ‘Well’, you could say, ‘the great moment is upon us. Don’t screw up.’
As we enter this new world, our first impressions are that it is bewilderingly complex and hostile. By ‘new environment’ we mean higher risk free rates, higher ambient volatility, higher stock bond correlation and lower, but not necessarily negative, returns to traditional betas. As regime shifts go, this is the real thing, as these characteristics are all inextricably interlinked. The complexity arises from the interplay of drivers – market positions and flows; monetary and political policy; and fundamental economics – which have all for so long been mostly subordinate to QE. The hostility comes from the rise in risk free rates and the challenging adjustments required by the normalisation of market volatility.
The links between rates and volatility are so multifarious as to be pretty robust. At the most basic level, cheaper money and lower volatility generally lead to higher leverage: both the cost and the risk of leverage are lower. This relationship must have grown stronger as the instrumental use of leverage by asset managers becomes more common place (there have been times in recent years when alarmingly, turnover in bond markets has migrated entirely to the futures and swaps markets). Clearly the reverse is true too: the sharp rises in volatility in February and October were closely related to higher bond yields. There is clear statistical evidence in higher frequency data that the previously negative correlation between the price of stocks and bonds began to become more positive in the days leading up to these events, and of course the relation between lower equity and higher volatility has been well established for over a century.
The deleveraging process now affects all areas of the asset management world, but has been particularly obvious in the hedge fund industry through October and November. The risk represented by a book 200% net long vs 200% net short in 2017 is now much higher, so both sides need to be reduced. As this is an industry wide phenomenon, the reduction of commonly held positions is particularly expensive and typically this leads to losses, which leads some managers to expect redemptions…a double hit to the capital base which needs to be reflected in further reductions in the gross book supported by this capital. This gives several paths by which a sharp drop in equity markets so often causes the all too frequent and deeply frustrating losses in so called ‘Market Neutral’ strategies. (It is an important reason for thinking that the use of alternatives for diversification in the short term is such a dubious policy.)
Mini de-leveraging episodes are unremarkable and typically occur at least once a year. If, as in 2017, we get away without a proper one, returns often look great but then there’s hell to pay soon after (February 2018 et seq). But because de-leveraging is innately self-reinforcing it can become very unstable (as it did in August 2007 and again in September and October of 2008): it’s all about the momentum in the process. The way managers typically evidence this is to point at the relentless intra-day price action in which shorts go up and longs go down. Towards the end of the episode, the scale and pace of the moves decline gradually and so the probability that something more important starts to drive prices increases.
There are some quite good reasons for feeling that we are all but played out on this last episode. Net exposures in hedge funds are close to the lows in the US (this almost always comes down first) and gross exposures are, despite the carnage, still no worse than average. The rate of losses is declining quite fast – so momentum is abating. But perhaps of most importance is the outlook on the prime mover for all this…the rate structure. The YTD rise in bond yields is about as big as anything we’ve seen since the early 1970’s (when oil was going the other way and inflation was screaming north) and the forward curve has been groping around for the ‘neutral’ point. Powell’s commentary has been increasingly supportive of the view that we are close (‘“just below the broad range of estimates of the level that would be neutral for the economy”) and the surge in stock prices this triggered suggests the market has taken it as pivotal.
This is not to say that it will be plain sailing from here: the stock bond correlation has further to go as does the generalised volatility transition if we are to revert to a more typically reflationary world. CTAs have big long USD positons against pretty much everything… which might make you nervous given the above narrative. But these are details by comparison with the clearance we have just been through. One could argue with some conviction that the alpha opportunity from markets is better after positions have been cleared out, and particularly in a world with such a clearly stretched opportunity set in the valuation of defensive vs growth assets. With the outlook for the traditional betas more finely balanced, the role of hedge funds in the portfolio looks pretty constructive.
The turbulent environment for active management continued from October into November, with further losses across the hedge fund universe, albeit generally of small magnitude. The worst hit strategies were Equity Long-Short (as in October) and Credit (as reverberations from the risk asset sell-off started to be felt in the corporate bond markets). Similarly to October, Macro strategies did better, in particular Discretionary Macro with mixed performance from CTAs. One bright spot on the hedge fund landscape was in Merger Arbitrage, where spreads narrowed on positive news across a number of deals.
In Equity Long-Short, the chief culprit for the losses were positions bought in early late October or early November in a ‘buy-the-dip’ trade only to be hit again by another wave of selling in mid-November. Data from prime brokers suggests that daily losses to momentum factors were even more pronounced on some days in November than they were in October, suggesting that losses were being driven more by alpha and less by beta this month (since the overall market declines month-on-month are less significant).
More broadly, market gyrations have generally been a negative for all sub-strategies within ELS, with faster trading managers hitting stop losses and missing the leg of the move in their favor. In particular, there are factor exposures (such as Japanese Value) which performed well in October that sold off in line with other factors in November, again supporting the idea that hedge fund losses were more widespread and alpha driven in nature.
Quantitative Equity and Statistical Arbitrage managers continued to suffer in the face of significant deleveraging pressure within the strategy. A number of managers posted a monthly loss in the mid-single digits which is significantly outsized for this strategy. Aggregate risk factor models produced by prime brokers support the idea that losses in this strategy are at least as painful as October.
The continued volatility in equities and the sell-off in crude oil, among other factors, led to losses spreading into Corporate Credit markets. US investment grade outperformed leveraged loans and high yield helped by lower treasury yields, but the floating rate leveraged loans asset class saw heavy retail outflows in the month after seeing steady inflows for the most part of the year, pressuring secondary market valuations. Lower-rated high yield credits meaningfully underperformed in November reducing the YTD outperformance vs. higher-rated names and most US high yield sectors were in the red with the Energy sector leading on the way down. US high yield primary market activity remained fairly subdued for another month.
Corporate Credit hedge fund managers (with a few exceptions) posted negative returns in November. Managers with exposure to US and European financials, commodity-related credits and post-reorg equities underperformed. Market hedges and select single-name credit shorts were profitable but the gains were generally not enough to offset the markdowns on the long side of the portfolios. Spreads were wider across most securitised product sectors in November in sympathy with corporate credit. Legacy RMBS bonds outperformed the higher beta CLO and credit risk transfer sectors. Most Structured Credit mangers posted modest gains/losses in the month with positive P&L from interest income and portfolio hedges offsetting the mark-to-market losses.
Discretionary Macro managers are generally enjoying the return of volatility across asset classes, although performance in November was more muted as bonds and the USD tended to trade in a more range-bound fashion during the month. Managers’ focus is increasingly on the FED policy path from here and the implications of tighter financial conditions. Hedging strategies targeting convexity or long-volatility continue to perform well and are seeing increased interest from investors given the global pick up in volatility.
CTA managers generally suffered losses driven by the whipsaw behavior of equity markets through the end of October and the month of November. The general lack of trends in bonds and FX meant that attribution of returns to these asset classes was muted. The largest differentiator between managers’ performance was the level of exposure to commodities, in particular to Natural Gas, which saw high levels of volatility throughout the month.
Given their predisposition to correlate to losses in equities during periods of stress, it was unusual to see event driven spreads normalising following the October volatility. Merger transactions generally continue to progress on pace with their forecasted closing and during the month Chinese regulators approved some key pending mergers which gave assurances to market participants. The pipeline of event activity remains robust with cross-border transactions continuing as a core theme in the sector. More broadly, Relative Value strategies produced mixed returns, with the worst performance coming from managers exposed to deleveraging within their sub-strategy and the better performance coming from short term strategies that benefit from the elevated level of volatility across markets.
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