FRM Viewpoint - October 2018
- The HFRX Global Hedge Fund Index fell -3.11% in October, bringing its YTD return to -4.30%.
- Hedge fund performance was extremely varied, with Managed Futures and Equity focused strategies struggling most.
- Markets have grown more volatile as earnings growth appears to have peaked and rates have moved higher.
- The equity market pull-back in October was the largest and most globally coordinated retracement since January 2016.
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 seeking 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 performed 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 may be increasing.
Discretionary Macro managers have generally 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.
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 -1.99% in October and up +0.58% year-to-date …||+ Managers are rotating exposure to US merger opportunities …||<> Technology deals lead in North America, Media & Telecom lead Western Europe and Industrial deals lead in Asia/Emerging Markets …|
|+ Global M&A deal count and volume remained robust in October with 2018 still on track to be one of the best years in recent history.||<> Managers continue to focus on convergence of Media and Telecom companies, vertical transformation of healthcare providers and pharmacy benefit managers.||- Cross boarder M&A has slowed due to uncertainty around US/China trade conflict.|
Equity Long-Short (ELS)
|+ October saw equity markets suffer one of their biggest drawdowns in recent years, led by growth names globally …||+ The increase in market volatility is providing attractive entry points for trades on the long side in over-sold long positions trading below their fair market value …||<> Rising interest rates and a growing discount rate continue to worry market participants …|
|- Equity Long-Short hedge funds experienced poor performance from net equity exposure and from alpha losses during the month.||- Single stock reactions to earnings were extremely pronounced, with many stocks dropping substantially after disappointing earnings.||+ Despite the sell off, indices of growth stocks remain in positive territory for the year while broader indices have been pushed into negative territory.|
|<> Corporate credit markets came under pressure in October alongside other risk assets as the S&P 500 Index fell the most since September 2011 …||+ Broad credit market spreads have remained well anchored despite the uptick in equity market volatility …||<> Fund flows were mixed with large outflows for HY bond funds (-$6.0bn; JPM) and inflows continuing for the tenth consecutive monthly inflow for loan funds …|
|<> Although outperforming equities broadly, US corporate credit markets generated negative total returns.||<> The opportunity set for Distressed remains constrained by the limited universe of distressed and defaulted paper with only idiosyncratic sector opportunities.||<> Default activity inched higher with four companies defaulting on $4.9bn in bonds and loans, a seven month high.|
|<> October saw equity markets regaining their place at the epicenter of market volatility …||+ With the VIX Index experiencing a sharp upward move in October, volatility arb managers are facing a richer opportunity set after years of financial repression …||<> There are signs of an impending regime change with the “buy the dip” strategy struggling for the first time in many years …|
|<> Divergent monetary policy, differing growth outlooks, and idiosyncratic regional politics continue to underpin the global macro outlook.||<> US rates underperformed European rates, with meaningful divergence as they moved in opposite directions in October.||<> Macro managers are focusing on the effect of the US midterm elections on markets, with an eye on Fed policy path and underlying economic strength.|
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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