Investment Strategy - Q1 2019
- Fed policy uncertainty and political instability are likely to lead to a market of sustained higher volatility. Access to hedge funds that generate alpha is highly valuable in this environment.
- Relative Value is our favoured strategy as we expect it to capitalise on opportunities that arise from volatile markets.
- Our outlook for Credit is negative, however we retain a healthy list of Distressed managers as we believe corporate defaults will increase.
2018 was a difficult year for financial markets with almost all assets generating negative investment results, leaving investors with few places to hide. In aggregate, hedge funds also had negative returns, with the spikes in equity volatility in February and October in particular proving challenging to navigate. However, results relative to markets improved in December when stocks dropped sharply.
Many market observers expect a sustained environment of higher volatility. We agree with this view, which suggests that investing may become more difficult than it has been for much of the quantitative easing period of the last ten years. Potentially peaked global growth, uncertainty around Fed policy, and political instability across regions (Brexit, Italy, trade war) may fuel volatility across asset classes.
In this vein, 2018 provides us with many data points that we will use to critically analyze our investments. This re-underwriting will be the main driver of changes to our portfolios in Q1, as we do not believe that drastic changes to our strategy allocations are necessary. Subject to portfolio needs, we plan to modestly trim Credit and Equity Long-Short in favor of Relative Value and Macro. Portfolios with an over-allocation will reduce their Event Arbitrage risk, while we intend to increase Volatility Arbitrage strategies.
HEDGE FUND PERFORMANCE REVIEW
Against a backdrop of periods of heightened volatility in 2018, particularly in equity markets, diversified hedge fund portfolios were increasingly able to help protect capital. While the HFRI FOF Diversified Index ended the year with a Q4 return of -4.74% taking 2018 returns to -3.43%, the relative performance during stress markets improved throughout the year as hedge fund managers adjusted to the new environment. This dynamic profile makes us optimistic about the outlook for hedge funds in an evolving market regime.
Equity Long-Short managers had a tough year, as poor Q4 performance brought the HFRI Equity Hedge Index 2018 return to -6.94%. 2018 proved to be the worst year for alpha in the last ten years, following a stronger 2017 in which the space generated alpha and additionally benefitted from long exposure to risk assets – a stark contrast to what we observed in the last year. In Q4, managers were hurt by beta exposure amidst October’s initial market sell-off before losing again on failed attempts to buy the dip. Managers also struggled on the alpha side as they were forced to deleverage following large losses in early October and continued to struggle from factor exposures such as Momentum. Alpha generation improved in December, but absolute returns were further affected by beta to equity markets.
Following a period of outperformance through the first three quarters of 2018, Credit turned during Q4, with negative performance resulting from the widening of spreads that were previously trading close to post-crisis tights, particularly in Corporate Credit. The fall in oil prices in combination with the risk-off sentiment, including in the financial sector, impacted manager performance negatively. High yield spread widening in December caused losses for long-biased Credit strategies; however, hedged credit and convertible books held up better. In Q4, as carry largely offset losses from spread widening, Structured Credit continued to build upon its positive performance over the first three quarters which had been attributable to a combination of carry and mark-to-market gains.
Event Arbitrage managers generated positive returns in 2018, which was one of the most noteworthy years in recent history in terms of deal activity. In Q4, many merger transactions continued to progress at a rapid pace toward closing. More broadly, Q4 was marked by mixed returns across Relative Value strategies with some managers negatively affected by deleveraging and others benefitting from elevated volatility. For Statistical Arbitrage strategies, a mixed 2018 continued in Q4. The strategy handled the initial sell-off in October, but experienced pain during the ensuing period of deleveraging. December was generally a stronger month for Statistical Arbitrage Funds as high single stock volatility generated better trading signals.
Macro Funds underperformed expectations in 2018 which was partially driven by high downside participation in February, followed by lackluster returns thereafter. However, results varied widely between sub-strategies and managers. Discretionary managers with a long volatility profile and those with interest rates trading expertise globally were mostly positive for the year. Trend followers were wrong-footed when trends reversed in February and October, but were positive in December. Emerging Markets focused Funds were rarely able to produce positive performance from the volatility in currencies and equities as the rapid deterioration in EM assets during the first half of the year caught many by surprise.
FINANCIAL ENVIRONMENT OUTLOOK
Our outlook for the financial environment is that peaked global growth, uncertainty around Fed policy, and political instability across regions (Brexit, Italy, trade war) will continue to generate heightened volatility across asset classes. In our view, this means that traditional investing could be challenging. However, at the same time this presents interesting potential opportunities for hedge funds – which is particularly true in Developed Market Fixed Income, Volatility markets globally and Emerging Markets Equities. Meanwhile, we believe Corporate Credit markets are poised to face a more challenging 2019.
The macroeconomic environment has become more fragile, though we do not believe that a recession is likely in the near-term. Global growth appears to have peaked with tightening financial conditions causing headwinds. To be clear, growth appears to be coming down from a period of strength with a number of global economies experiencing expanding composite PMI’s in 2018 (97%).1 Furthermore, we have been in an extended period of Fed policy success given that six of the last seven months have ranked in the 99th percentile since the 1960s in terms of the Fed achieving its dual mandate goals.
Investors’ focus has turned increasingly to Central Bank policy; a theme which could have a large impact in 2019. Monetary policy in Q4 remained on the path outlined earlier in the year, with the Fed implementing additional hikes and reducing its balance sheet. The ECB ended a period of balance sheet expansion by terminating net asset purchases in December, while also downgrading its growth forecast.
The potential for a pause in rate hikes by the Fed is a contributing factor to our more positive view on Emerging Markets. This is because we believe Emerging Markets have the potential to outperform Developed Markets in the short-to-medium term given the macroeconomic adjustment and more attractive valuation levels. One exception to this however, is China, where growth slowdown and trade tensions may be a drag on returns. This also weighs on our outlook for Commodities – specifically our bearish view on industrial metals due to the possibility of decreased demand from China.
Ongoing trade war concerns continue to impact both China and the US. While tensions de-escalated briefly following the G20 summit on November 30, the respite was short-lived as markets quickly discounted the stability of any truce between the two nations in early December. However, we believe that an agreement on re-arranging global trade flows could be a catalyst for a pronounced shift in market sentiment.
While we remain neutral to negative in Fixed Income across key countries, we do see more attractive opportunities in Developed Markets than in the previous quarter. We particularly see this in the US and UK – the former being attributable to the aforementioned potential for a Fed pause in early 2019 and the latter due to the possibility of volatility on Brexit uncertainty.
We have a pessimistic outlook for Corporate Credit as it could be the next asset class to bear the brunt of the adjustment to the Quantitative Tightening market regime. We started to see spreads widen in Q4, with US HY and CCCs trading approximately 65% wider versus close to post-crisis lows in late September/early October (Figure 1 below). While spreads in December moved above historical median levels, they remain exposed to a deterioration of fundamentals. On that matter, we remain concerned about the high leverage outside of the financial sector.
Figure 1: US High Yield (CCC – BB) spreads
Source: Bloomberg, BAML; As of December 31, 2018.
In summary, as markets react to the developments in monetary policy and political events during 2019 and the outlook for global growth becomes less favorable, we expect to see continued volatility across asset classes. Therefore, we continue to add to strategies that can potentially take advantage of volatility while maintaining the defensive stance in portfolios that we set out last quarter.
Hedge fund returns in 2018 were negative as the transition from a low to a high volatility regime was a challenge. However, we believe that managers are now in a better position to successfully navigate the economic and political risks that could keep fueling bouts of volatility. Unlike some other risk assets, expected future hedge fund returns have not been reduced by compressed risk premia from Quantitative Easing. On the contrary, the declining impact of asset purchases by Central Banks and the normalization of interest rates may improve the outlook for hedge funds.
Clearly, hedge fund returns were varied in 2018, and in aggregate disappointing. But we are using our observations to conduct a rigorous re-underwriting of Funds. Our strategy focus will continue to emphasize managers that are not reliant on rallying risk assets, but instead have a well-defined process for seeking alpha.
Relative Value2 remains our favored strategy as we believe it has the best potential to generate alpha. We are optimistic for Event Arbitrage. Trading-oriented event managers that provide liquidity to the market on dislocations are positioned to potentially capitalize from other investors’ need to move large blocks of shares in less liquid markets. Furthermore, sustained market volatility may allow managers to trade spreads between related securities. We also believe that the backdrop for Merger Arbitrage continues to be sufficiently attractive to justify a material capital allocation. However, merger volumes could decline from levels we saw in 2018, one of the strongest years in recent history, due to the expected decline of global cross-border transactions. Therefore, we will trim the allocation in portfolios which have had an over-allocation to Event Arbitrage.
We believe Fixed Income Arbitrage results could improve with the normalization of monetary policy and higher interest rate volatility globally allowing managers to potentially generate better returns than in 2018. We are actively researching the space for potential additions to our list of approved Funds.
During Q4 2018, we initiated a new investment in Volatility Arbitrage and we anticipate a further increase of our allocation to this strategy in Q1, with an emphasis on equity dispersion. We are focusing on programs that have the potential to outperform during difficult periods for risk assets. The challenge is to balance the desired skew profile with the opportunity costs during low or declining volatility regimes.
Our focus in Statistical Arbitrage has been to upgrade our list of approved managers. We were negatively impacted by losses in fundamental quant strategies. Based on the assumption that the Sharpe ratio of these strategies will not recover from the decline in the last few years due to the broader use of systematic investing, we have exited most traditional quant hedge fund managers in order to allocate capital to Funds that deploy strategies with higher barriers of entry (such as those utilizing machine learning techniques or alternative data sets). As a result, we expect our Statistical Arbitrage allocation to be more defensive and to potentially benefit from higher equity volatility.
While Credit outperformed expectations last year, our overall outlook for the strategy remains negative. Looking forward to 2019, we see the opportunity set becoming more limited across most sub-strategies. In Corporate Credit, managers remain focused on idiosyncratic credit selection amidst a backdrop of higher spread volatility, a limited universe of stressed/distressed credits and potential risks on the horizon (e.g. GE downgrade, a pickup in fallen angels). We continue to have a preference for Credit Long-Short over Credit Value (Distressed) given the level of credit spreads and a modest distressed and defaulted universe. Structured Credit performance is increasingly reliant on carry as the space begins to face potential fundamental headwinds. In Convertible Arbitrage, the opportunity set has become more attractive in light of higher yields and volatility, though elevated issuance may pressure secondary market valuations in the near term. We will continue to opportunistically increase allocations to Convertible Arbitrage managers driven by bottom-up manager selection.
The increase in corporate leverage outside of the financial sector and the deterioration of credit standards could eventually lead to an increase in corporate defaults. We retain a robust list of Distressed managers that we could allocate to should this scenario materialize. We expect to be reactive, not proactive; previous expectations about a materially better opportunity set such as in European corporates have proven to be incorrect. We also believe that betting on tested and credit friendly jurisdictions, namely the US, could lead to the best risk-adjusted returns over the long term.
Discretionary Equity Long-Short has been a negative alpha contributor this year. International exposure and bets on Momentum stocks were the main sources of losses. De-leveraging of crowded themes plagued many Funds in Q4. However, by December positioning across Funds was light.
We believe the environment is favorable for tactical Funds, with the challenge lying in sourcing sufficient top quality capacity. We are reviewing our Equity Long-Short list and expect to replace investments that have underperformed expectations with managers that we feel have a genuine research edge and can navigate choppier markets.
Given our thesis about a secular trend of alpha transitioning away from discretionary stock picking to systematic hedge funds, the bar for adding new Equity Long-Short managers will be high.
The tail end of 2018 saw an increasingly interesting opportunity set for Macro managers. Depending on the outcome of our due diligence process, we may therefore increase exposure to certain Macro strategies. Against the backdrop of a shifting market regime and tightening financial conditions, we see a more interesting opportunity set in particular for managers who may benefit from more active monetary policy globally, reduced Central Bank balance sheets and higher interest rate volatility.
We continue to have an underweight view on Commodities strategies, as managers have struggled to generate returns with daily news flow on trade agreements overwhelming fundamentals in agricultural products, for example. Therefore, we plan to reduce our minimal allocation in the space.
We maintain our position that we should not time trend-following, but that it does play an important role in portfolio construction. In Q1, we will be actively researching trend managers accessing alternative markets, to which we may increase our allocation.
Alternative Risk Premia remains an important facet to many of our portfolios. At the outset of our move into the space we chose to use our in-house capabilities to build a product that suited our clients’ needs, rather than allocating externally. This was based on an assessment of the relative strengths of both our internal strategies and external offerings. The difficulties in the broader space last year have been well documented. Through this period we have seen the benefits from the transparency offered to us from the internal relationships. This has strengthened our conviction in our initial decision.
We will continue to allocate to the strategy in many of our portfolios based on individual portfolio needs and with an in-depth understanding of the underlying allocation characteristics.
1. Goldman Sachs, as of August 31, 2018.
2. We include Event, Fixed Income, Volatility and Statistical Arbitrage strategies when discussing Relative Value.
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