FRM Early View - October 2018
- Market returns were equity-specific and technical
- Higher inflation, positive correlation and poor market liquidity are still a concern
- Hedge fund performance extremely varied with significantly more losses than gains
Last month we published one of our more bearish Early Views of the last few years, and it is surprising that we were so prescient. There have already been reams of commentary on the recent equity market behavior; therefore our concise summary of market returns in October is that it was equity-specific and technical. Volatility in other asset classes was contained, and the losses were (at least initially) caused by a position clear-out in growth stocks and a somewhat delayed repositioning in reaction to higher bond yields rather than a material deterioration of fundamentals at either the corporate or sovereign level.
As always, we are trying to keep our focus on the bigger picture. While equity markets have entered correction territory in most developed markets, barring a few mark-to-market losses here and there the financial system appears to be functioning fairly well thus far. There is, however, little clarity as to what active managers should do from here. ‘Buy-the-dip’ has been the best trade of the last decade, but while drawdowns of 5-10% in the S&P 500 have all been recovered in a matter of weeks, there have only been three drawdowns greater than 10% since 2008 – and these each took over 6 months to recover (even with the help of QE). Another concern is that we may be at a turning point in preferred risk factors of markets. We’ve had roughly a decade of returns to the Growth factor since 2008, which followed eight years of returns to Value from 2000-2008. With rising bond yields and rising inflation, a return to a Value-led market is clearly possible. With many market participants who were not around in 2000, there is an enhanced sense of confusion.
More broadly, none of the concerns that we outlined last month has really emerged yet. We are still worried about negative feedback loops arising from higher inflation, positive correlation between equities and bonds, and poor market liquidity. These systemic shocks could spread across all asset classes. We are keeping a close eye on LIBOR rates, where the 3m USD rate has risen from a stable 2.3% through the summer to around 2.5% and the Fed Funds rate is testing the top of the range set by the central bank. The evidence of the last year shows that equity markets don’t seem to like long rates rising with any kind of velocity. It is easy to see how we could have further concerns around the discount rate as the Fed continues to exit QE and shrink their balance sheet.
In many ways, the most troubling aspect of all of this is that the macro data remains good. The US GDP print of +3.5% was ahead of expectations, but there are growing numbers of commentators who believe that growth could weaken next year as the YoY effects of Trump policies such as the tax reform roll out of the data. While corporate data is broadly holding up, the weaker revenue data from Amazon and Alphabet in mid-October caused another wave of market corrections (despite pretty solid earnings figures from both companies). If the fundamental data does weaken over the next six months it could lead to a prolonged period of equity market volatility.
Hedge funds also detracted in October on the whole. We know that it is hard to add alpha in the immediate vicinity of an inflection point due to broad based deleveraging, as managers will generally be reducing risk in reaction to the increased market volatility. The new and potentially less understood aspect of this is whether investors reduce their exposure to Hedge Fund strategies via daily liquidity products. A quick look at some of the largest players with daily liquidity products suggests this has been happening in October.
Our experience is that hedge fund portfolios may deliver their risk betas over the short term in periods like this, with broadly no alpha. For example, a portfolio with 20% net exposure to equities might lose 2% in a 10% market correction.
We feel it is the period after an inflection point that is the time for hedge funds to earn their keep. Not just by potentially beating the equity market (the game was never thus) but by tapping into investment strategies that haven’t worked for much of the last decade. As noted earlier, Value-based equity investment strategies have lagged other active approaches since the financial crisis – it is quite rational to believe that this skill set may be required to profit from equity markets in a higher rate world. Long-volatility strategies have struggled in a world where the VIX index sets a new low seemingly every month, but these have a new lease of life in a world where equity market volatility returns to more historically ‘normal’ levels. Discretionary Macro strategies work better in our view when volatility is higher in all asset classes, as there are more big swings in macroeconomic performance from which they can potentially hit the kind of home runs necessary to generate attractive returns from this strategy. Different kinds of ‘mean reversion’ strategies might suddenly find more attractive entry points for trades as we move from a world dominated by momentum factors.
As allocators to hedge funds we now have a much wider toolbox of strategies to build portfolios for the next few years and are genuinely excited by the opportunity to potentially generate alpha in this environment. However, we have been wrong about the end of the cycle enough times to know that things never play out quite as expected. The risk to hedge fund returns in the short term is a strong equity market rally into the end of the year just as many managers have taken down risk and positioned for a more turbulent world. In which case we could see subdued returns and continue to grumble about the lack of opportunity.
Hedge fund performance was extremely varied in October, but with significantly more strategies with losses than gains. The worst performing areas were Managed Futures and equity focused strategies, in particular Equity Long-Short and Statistical Arbitrage, with Credit and other RV strategies also generally recording negative performance. Better performance was seen from Macro strategies, some idiosyncratic strategies in FX and Commodities, and in Value driven strategies in Japan.
Equity Long-Short managers detracted broadly in line with their beta exposures, but managers with higher net exposure generally struggled more on the alpha side of the equation as well, having to take down exposure in reaction to losses. The challenge for ELS managers is whether to maintain sufficient risk to benefit from any market recovery while risk managing losses at the position and portfolio level. Trading focused managers generally performed positively through the first half of the month, but also struggled to navigate the second half, with many taking long exposure after the initial sell-off and failing in their attempts to buy-the-dip.
Statistical Arbitrage has also had a tricky month. Some managers carry futures strategies as part of their multi-strategy allocation and these were hurt by the same moves as the momentum strategies. The equity based strategies generally handled the initial sell off better, and were close to flat through to October 12. The second half of the month was more painful for these managers, and follows a pattern we are starting to observe in these short term volatility spikes. Cross-sectional equity strategies have generally been unaffected by the initial moves (which tend to be either Industry/Style rotations, or more of an index move, rather than high idiosyncratic volatility moves), but the following period has been challenging due to deleveraging.
For Event strategies, spreads perceived as ‘risky’ widened whereas ‘low-risk’ situations remain well bid. Special situation equities was the leading detractor across the event driven space; however, many managers came into the month with conservative risk profile and are prepared to opportunistically add if a significant spread dislocation emerges.
Managed Futures generally detracted as they came into the month with a long bias to US equities given their recent upwards trend. As the month progressed and equity markets fell, many managers covered their long equity exposure and built short positions which helped to temper losses in the second half of the month. Other asset classes were mixed, with positive returns from bonds and FX and negative returns from Commodities. As can be the case in inflection points, short term strategies generally did better than longer term strategies as they were able to react to the market sell-off more quickly. One other point of note on Managed Futures managers in October is that they would often find themselves long and short different regions in the same asset class, suggesting that macroeconomic dispersion is increasing.
Discretionary Macro managers have benefited from the resumption of US dollar strength across the board as well as the underperformance of US fixed income against Europe. Emerging markets has stayed on the sidelines from the main market adjustment in October as it had largely repriced earlier in the year and there were some positive idiosyncratic developments, primarily the Brazilian election results which were market friendly and triggered a meaningful rally in the country’s stocks.
Global corporate credit markets tracked equities lower in October but outperformed on a relative basis. US leveraged loans helped by the floating rate coupons held up during the month in which US 10-year treasury yields finished close to multi-year highs. Performance was more challenging across the high yield and investment grade markets. Within US high yield most sectors finished in the red in October. Surprisingly, there was little dispersion in returns across the rating categories with lower-rated credits maintaining their YTD outperformance vs. higher-rated names. The past few months’ trend of relatively light primary market activity in US high yield continued in October, proving support to the market. Flows were decidedly negative for high yield bond funds in the month.
Corporate Credit manager performance was mixed in October. Credit Long-Short managers as a group outperformed the long-biased Distressed managers with losses for the latter driven by exposure to post-reorg and value equities. Credit Long-Short managers that were positive in October tended to have a defensive bias with relatively low credit beta. Single-name credit shorts and portfolio hedges were a source of gains for these managers while the long books also held up in the face of spread widening in the broader credit markets. There was modest spread widening across most securitised products sectors in October but it lagged the widening in corporate credit. Bid/ask spreads were also modestly wider on the month. Most Structured Credit managers were positive in October though as carry offset any spread widening. In addition, managers generally saw positive attribution from equity, corporate credit and CMBX hedges.
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