FRM Viewpoint - November 2018
- The HFRX Global Hedge Fund Index fell -0.62% in November, bringing its YTD return to -4.89%.
- The turbulent environment for active management continued from October into November, with further losses across the hedge fund universe.
- The continued volatility in equities and the sell-off in crude oil, among other factors, led to losses spreading into Corporate Credit markets.
- Idiosyncratic regional politics and impactful geopolitical events continue to drive the global macro outlook.
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 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 rangebound 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.
Summary of performance drivers by strategy
|Key:||+ Positive factors and/or drivers||<> Neutral factors and/or drivers||– Negative factors and/or drivers|
|Alternative risk premia||Trade examples1||Environmental factors|
Relative Value (RV)
|<> The HFRI Event Driven Index was down -0.33% in November and up +0.70% year-to-date …||– Managers believe bouts of volatility may provide opportunity to enter in spreads at more attractive levels in the coming months …||– Some speculate that the ongoing Brexit negotiations are impacting M&A activity …|
|+ Global M&A volume continues to decline relative to the upsurge of activity in the first half of 2018.||<> Managers’ portfolios naturally de-risked as they exited exposures on gains.||+ Managers have rotated exposure to US merger opportunities as European opportunities have slowed in recent months.|
Equity Long-Short (ELS)
|<> Equity markets continued to exhibit high levels of volatility in November, with further declines in risk assets through the first part of the month …||– The most precipitous decline in the Market Neutral Momentum factor since July occurred in mid-November …||<> The recent risk reduction from hedge funds has pushed valuation metrics in markets to more extreme levels …|
|– The MSCI World Index exhibited a 5.2% peak to trough intramonth sell-off, and still finished in positive territory for November.||+ Returns from most well-defined market neutral risk factors (such as Value, Quality, Earning Momentum etc) were negative during the month.||<> Following October the VIX has oscillated around 20, and hasn’t dipped below 16 on even the most benign days.|
|+ Fund flows were negative in November with -$1.9bn coming out of US HY bond funds while leveraged loan funds saw a - $2.9bn outflow, the largest since December 2015 …||<> Broad credit market spreads have seen a sharp reversal in recent weeks after trading close to post-crisis tights …||– Structured Credit spreads are wider across most sectors in sympathy with corporate credit, with higher rates and economic surprises as key risk factors …|
|– Performance for most managers was characterised by a long tail of negative performers and a few meaningful contributors largely dirven by idiosyncratic news.||<> US financial preferreds, European financials, energyrelated credits and equities, and gaming equities were among the largest detractors for managers.||<> Default activity declined MoM with only three companies defaulting on $1.6bn in bonds and loans.|
|<> Corporate Credit managers had a challenging November with financials and energy-related credits and equities particularly hit hard …||– Performance for outright convertibles was mixed with US and EM converts outperforming Europe …||+ The market’s inflation expectations for the next ten years have fallen, and an imminent rate pause or slowdown in hikes is likely …|
|<> Broad credit market spreads have seen a sharp reversal in recent weeks after trading close to post-crisis tights.||+ Securitised product sectors outperformed higher beta, more credit-sensitive sectors.||+ Default activity declined month-over-month with only three companies defaulting on $1.6bn in bonds and loans.|
The above summary is based on FRM’s opinions on performance drivers across the hedge fund industry and is not representative of the investments made by FRM. 1. The herein mentioned examples are intended as illustrations of typical investment consideration and/or strategy implementation. It should not be construed as indicative of potential performance of the fund or strategy or any investment made by the fund. It does not constitute a recommendation or investment advice or solicitation to buy or sell any particular securities and should not be considered as any investment advice or research of any kind. There can be no guarantees that similar opportunities will be available in the future or that any opportunities identified will provide similar results.
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