Investment Strategy - Q2 2018
Hedge funds were able to weather the change in the market environment relatively well in the first quarter of 2018. The sudden spike in equity volatility in February proved challenging for strategies that were betting on trends, but with Relative Value and Credit managers broadly positive, diversified hedge fund portfolios outperformed equity indices. Volatility prevailed in March with markets reacting to global trade concerns and the scrutiny of technology companies. Despite this, many managers showed positive results. And with the equity directionality of trend followers reduced, many of our portfolios outperformed equity indices.
We believe that financial markets are transitioning towards a late cycle regime and could, despite continued global economic growth, experience higher volatility across asset classes and lower risk adjusted returns going forward.
Our allocations for the second quarter will therefore focus on Relative Value strategies with limited directional exposure at the expense of long-biased managers. We will reduce our allocations to US Equity Long-Short in favor of regions where we anticipate higher alpha generation potential.
Hedge fund performance review
Hedge fund performance in the first quarter was generally positive despite the equity markets experiencing losses and volatility increasing sharply.
Hedge funds had a noteworthy start to the year with the trends that prevailed through 2017 accelerating in January. Equities rallied the most since the late 1990s despite sharply higher interest rates. The dollar counterbalanced some of the tightening from fixed income markets by weakening further against most currencies.
The sudden increase of equity market volatility and the sell-off in stocks at the beginning of February resulted in losses across most strategies, led by trend following managers, but diversified hedge fund portfolios generally outperformed stock indices.
While the market stress was mainly concentrated in equities, trend followers also experienced losses in growth sensitive commodities and in foreign exchange, with the US Dollar reversing its down trend. These systematic strategies started to adjust exposures and thereby did not participate fully in the rebound that established itself by mid-February, leaving many managers in negative territory for the year. Quantitative equity strategies struggled as fundamental stock signals suffered from what appeared to be a leverage unwind in the second half of February.
While most Equity Long-Short funds saw losses, some were still able to deliver alpha. Some discretionary equity funds interpreted the equity sell-off as temporary and technically driven in nature and took the opportunity to add to positons.
Relative Value trades to capture a convergence of spreads that had become dislocated failed to deliver gains. Merger Arbitrage funds held up with a competitive bidding situation in the broadcasting sector boosting returns late in the month.
With lower quality segments of the credit market being spared from volatility, credit hedge funds had modestly positive returns despite high yield funds reporting escalating outflows. The mismatch between less liquid credit longs and more liquid, on-the-run, short positions worked in the managers’ favor.
March generally saw better overall performance in hedge funds than what was experienced in February. Most hedge fund strategies, with the exception of Event Arbitrage, ended the month without suffering the same drawdowns experienced in the equity markets. A perceived hawkish Fed rate decision in the US, potential for a trade war, and technology sector woes triggered by the Facebook data scandal all contributed to late-month weakness in equities. Trend followers, after de-risking in February, posted mixed results. Macro managers were generally able to take advantage of the continued widening in funding spreads. In Relative Value, some quantitative managers focused on technical strategies benefitted from equity volatility while managers focused on slower factor-driven strategies struggled in March. Returns of discretionary Equity Long-Short funds were mixed with European managers generally performing better than their US counterparts as the latter tended to have more long exposure to the hard hit technology sector. It was heartening to see fundamentals driving stocks and managers generating alpha particularly from the short side of their books, unlike February. After a favorable showing in February, Merger Arbitrage managers posted losses in March due to a lack of positive idiosyncratic deal news to offset the spread widening during the back half of the month. Performance for Credit hedge funds were mixed with Structured Credit managers outperforming Corporate Credit funds.
Financial environment outlook
Our financial market outlook reflects the view that despite continued economic growth, risk-adjusted returns across asset classes could be lower than in recent years as higher interest rates, higher volatility and increasingly unstable correlations drive a new market regime.
Global economic growth has remained firm throughout Q1, albeit with weakening tendencies towards the end of the quarter in Europe. Economic indicators in the US, where corporate earnings are at record levels, mostly point to continued strength of the economic expansion. Following the 2017 US tax reform another fiscal stimulus, in the form of a large budget, was announced and effectively ended the short period of modest austerity through sequestration of the Budget Control Act of 2011. So the broad picture is comparable to our last quarterly outlook.
What has evolved in our view is that the conditions prevalent during the last five years represent an increasingly challenged equilibrium. The era of low inflation, easy financial conditions and low volatility may be coming to an end as the US economy begins to face late-cycle supply side constraints in the labor market and a crowding out effect on financing conditions from the budget deficit. This points towards lower forward looking risk-adjusted expected returns across asset classes in our view. We think inflation remains the most critical risk factor for markets as it has the potential to set in reverse the transmission mechanism of years of liquidity expansion and financial repression.
With the exception of growth, the pillars on which the risk asset bull market was built are showing signs of weakness, as higher rates and higher volatility deteriorate the risk-reward trade-off. This scenario doesn’t necessarily change the overall direction of equity markets – unless rates climb to a level at which they seriously undermine growth prospects – but it may make the path more volatile. We believe the outlook is less constructive for other asset classes which benefit less from growth and are more sensitive to financial conditions.
While the volatility spike in equity markets has captured nearly all the attention, there has been a significant increase in short-term funding costs. Chart 1 below shows the increase in three month USD LIBOR year-to-date.
CHART 1: 3-MONTH USD LIBOR (IN PERCENT)
There have been discussions into whether funding markets are experiencing conditions with challenges similar to those of 2008 or 2011; due to the widening of the spread between the LIBOR and Overnight Index Swap (OIS) rates. As other indicators such as cross-currency basis swaps don’t reflect any material market stress, the drivers of the LIBOR-OIS spread may be a combination of technical factors. Regardless, the steady increase of LIBOR has resulted in higher costs that could widely impact market pricing and therefore economic activity.
Any asset or strategy that has benefited from the search for yield and extension outwards along risk asset curves may face headwinds as financial conditions deteriorate. The developments that we think are the most relevant drivers of the changing shape of the market regime are the following:
- Higher rates
- Higher volatility
- Less stable correlation structures
These variables are all interrelated and have a high impact on market dynamics. Correlation structure is perhaps the least understood and potentially most dangerous of all three, as risk has been transferred in some investors’ portfolios from directional to short correlation.
A supportive factor for global financial conditions, which despite equity market volatility and higher yields remain accommodative, is the continued US Dollar weakness. The aggressive approach to change perceived unfair trade relationships that the US rolled out following the departure of a number of pro-globalization voices in the administration signals a likely preference for a weak Dollar.
These views translate into a higher emphasis on strategies that can potentially capture market dislocations in a higher volatility environment without delivering meaningful risk asset beta, and with limited reliance on portfolio construction techniques that can exhibit fragility during periods of unstable correlations.
In summary, we think markets are transitioning towards late cycle dynamics which historically tend to favor growth sensitive assets over funding sensitive assets. In this context, we believe there will be higher volatility across asset classes and lower risk adjusted returns going forward.
Our market outlook translates into a preference for hedge fund strategies that offer the potential to capture dislocations and provide liquidity. We focus on Relative Value strategies with limited directional exposure and trade structures around dislocations. This is in line with our preference last quarter, and in fact has been a prevailing theme in our asset allocation for a while. We will reduce our allocations to US Equity Long-Short in favor of regions where we anticipate being able to earn higher alpha.
Our research in 2017 was focused on adding diversifying systematic strategies to our existing manager list. In the coming quarters, we aim to capitalize on a high quality shortlist of potential opportunities spinning out of trading platforms.
A sustained higher volatility environment could result in more idiosyncratic opportunities for technical statistical arbitrage managers. Evidence of this has been observed during Q1. At the margin, higher rates will help value-driven strategies. Our long-term view of the Statistical Arbitrage space remains positive.
We continue to maintain a favorable outlook for Event Arbitrage strategies. Our optimism is rooted in expectations of a pickup in merger activity supported by the US tax reform legislation and the ongoing technological disruption. The tax reform has the potential to result in a repatriation of cash as well as facilitation of restructurings and asset sales. Despite a volatile Q1, deal activity has remained fairly robust in February and March. In fact, global mergers and acquisitions activity is up 50%+ year-over-year to more than one trillion dollars. Credit markets remain open to finance corporate control changes (albeit potentially at increasing costs).
A potential challenge to our constructive view is the increasing nationalistic economic reflexes. Chinese corporations have been important M&A participants and if Western economies – especially the US, of course – increasingly block these deals, it could impair future opportunities, as well as a number of larger existing trades in the portfolios of Merger Arbitrage managers.
Performance for Special Situations and to a lesser extent Relative Value strategies have been more mixed. Special Situation trades in particular may exhibit a higher beta to the equity markets due to generally longer expected event durations and softer catalysts. We had previously reduced our allocation to this sub-strategy and will maintain this stance.
Overall, we like Event Arbitrage with a bias towards hard catalyst merger and relative value arbitrage trades as we believe it can provide potentially attractive uncorrelated returns.
We have a neutral view on Credit hedge fund strategies. Within corporate credit, we are neutral on Credit Long-Short and somewhat negative on Distressed. Despite the recent significant pick-up in equity market volatility, broad credit market spreads are only slightly wider than post-crisis lows. The universe of stressed/distressed/defaulted names also remains fairly modest with only idiosyncratic distressed opportunities in sectors like energy, retail and healthcare. On the plus side, we believe there are still pockets of opportunity in capital structure arbitrage and opportunistic credit shorts. We have also seen a pick-up in fundamentally driven dispersion in US high yield sector returns over the past few months. If sustained, it could be a plus for the corporate credit opportunity set.
In Structured Credit, loss-adjusted yields in the mid-single digits still look reasonable to us with stable to improving borrower performance. However, given the strong rally and flatter credit curves, there is ever increasing negative convexity from any economic surprises.
We continue to maintain a focused list of approved Credit managers while monitoring downside risks from a potential spread widening event which could be triggered by outflows from fixed income funds in a meaningfully higher rate environment.
Many Equity Long-Short managers, after a noteworthy 2017, have continued to generate alpha in the face of increased market volatility in Q11. It is also encouraging to see favorable results from our core European Long-Short list (where we have been meaningfully overweight in many portfolios).
As long as single stock correlation doesn’t increase in lockstep, a higher volatility environment – absent of sharp spikes – could be a positive for Equity Long-Short strategies. Managers may be able to take advantage of short alpha opportunities given the potential for stocks to fall meaningfully in a higher volatility regime. We have seen prudent risk reduction from managers which we believe will leave them less susceptible to further declines in markets. We continue to see better potential alpha generation opportunities in Europe vs. the US where we are reducing our allocation. At the same time we are researching managers in Asia and will seek to capitalize on the improving quality of new launches and higher potential to deliver alpha in its less efficient markets.
The opportunity set for discretionary macro funds could generally improve, but we believe monetization will be inconsistent with high dispersion of managers’ returns to continue. Therefore, we have no intention to increase our exposure to these funds. Fixed Income focused relative value traders may be in a better position to generate more sustainable returns though, albeit at times with frustratingly low levels of volatility.
The weak US Dollar remains a key theme for Emerging Markets macro managers. As discussed in previous quarters, we are encouraged by the number of idiosyncratic trade opportunities across asset classes and expect to increase our exposure to these managers.
In the trend following space, we maintain a blend of core market momentum, momentum in exotic markets, as well as a mix of different speeds to navigate through the more challenging market environment. Additionally, managers’ non-trend models in the form of carry, value and short-term mean reversion may help to navigate periods of choppy directionless markets.
The ability to risk manage portfolios through Alternative Risk Premia has proven valuable in Q1. We continue to use Man’s risk premia to help complete clients hedge fund portfolio solutions. An additional option has become available with a Quality program, which can be used to add defensive characteristics to portfolios. We will maintain a substantial risk allocation to Overlays in most portfolios.
1. Equity Long-Short hedge funds (HFRI Equity Hedge Index) experienced significantly less of a drawdown than global equities (MSCI World Index).
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