Investment Strategy - Q2 2019
- We believe that economic growth will stabilise after a period of recent weakness driven by the pivot to dovishness by Central Banks, and fiscal stimulus in China. However, it is our view that further periods of volatility are likely as market liquidity remains challenged.
- We are reducing the overweight to Event Arbitrage as merger activity is falling and spreads are compressed.
- We are increasing our Statistical Arbitrage allocations based on the quality of managers we have been able to source.
Markets rebounded in Q1 2019 after a volatile quarter. Broad hedge fund indices were also positive, mainly driven by managers with a directional bias. Statistical Arbitrage managers were flat as both fundamental and technical signals generated mixed returns. Other systematic strategies, in particular Managed Futures, benefited in February and March from the strong rally in bonds.
We believe that economic growth will stabilise after a period of recent weakness driven by the pivot to dovishness by Central Banks, and fiscal stimulus in China. However, this does not take risks off the table for financial markets. Further periods of volatility are likely as market liquidity remains challenged.
The dovish tilt by Central Banks increases the attractiveness of carry strategies which can support return generation of portfolios which otherwise own sufficiently uncorrelated strategies. We are reducing the overweight to Event Arbitrage as merger activity is falling and spreads are compressed. Notwithstanding their muted performance in Q1, we are increasing our Statistical Arbitrage allocations based on the quality of managers we have been able to source.
HEDGE FUND PERFORMANCE REVIEW
Hedge funds enjoyed a positive start to the year, bolstered by the tailwinds of the Q1 rebound in markets. While strategies with exposure to risk assets (notably longer biased Equity Long-Short and Credit) dominated early in the quarter, those strategies that struggled during January’s initial market turn (i.e. Managed Futures and Discretionary Macro) rallied to lead performance during the second half of the quarter. The HFRI FOF Diversified returned 4.3% during the period.
Equity Long-Short managers started the year with positive returns, driven largely by beta exposure early on, however returns to alpha strengthened through the end of January into February as managers redeployed risk following the reductions that occurred in the previous quarter. Performance was further supported by a broad outperformance of small caps over large caps. March was a more difficult month for alpha as significant short covering resulting from Central Banks’ increasingly dovish tones supported equity markets despite weakening growth outlook and the rally in government bonds.
Corporate Credit managers followed a trend similar to the one seen in Equity Long-Short, with positive performance in January and February as global credit markets rallied. Distressed managers outperformed in January due to their more pronounced long bias as well as exposure to re-organisation equities. Credit Long-Short returns were also positive, albeit more mixed, as some managers were negatively impacted by losses from shorts and market hedges. Corporate Credit managers broadly benefitted from idiosyncratic P&L drivers in the first half of the quarter, such as the completion of the Puerto Rico COFINA restructuring and the bankruptcy filing of a gas and power company in January. March saw modest positive returns across the Corporate Credit space with fewer meaningful idiosyncratic return drivers. Structured Credit managers had a positive Q1 as well, though the rally in securitised products sectors lagged that of corporate credit, and returns were more modest, primarily driven by carry.
Event Arbitrage returns were positive during the quarter, driven by softer catalyst strategies on the back of equity market strength; these strategies generally carry a net long beta. Risk in the strategy was relatively low in the beginning of the quarter as managers waited to recycle capital into new transactions following merger completions at year end, and the US Government shutdown caused delays in regulatory approvals of merger deals and other corporate events. Exposures began to increase during February, and performance continued to be positive, before a quieter end of the quarter.
Statistical Arbitrage returns were broadly flat in Q1. In January, fundamental strategies were helped by a return to the Value factor, but technical strategies struggled. This reversed in February, when technical models drove positive returns during the first half of the month, and fundamental strategies were weak as almost all factor models had a poor month. March also lacked factor support for fundamental strategies, and technical strategies faced difficulties due to relatively low levels of equity market volatility.
Trend Followers had a difficult start to the quarter, suffering from the snap-back in equities, commodities (oil) and FX (euro weakness versus the US dollar). Performance took a positive turn in February as trends persisted, particularly in equity and FX markets, and continued to hold through March driven almost entirely by long rates positioning. Returns for Discretionary Macro managers were mixed and particularly muted during the beginning of the quarter due to a limited opportunity set amidst the equity market rally and stable yield curve and USD. Managers with long fixed income exposure were able to gain in March, though few Discretionary managers had the risk tolerance to take as large of bond exposures as Systematic managers.
FINANCIAL ENVIRONMENT OUTLOOK
Our outlook for the financial environment is that growth is likely to stabilise, but market risks are plentiful. Assets rebounded sharply in Q1 leaving return expectations of risk assets challenged. Sporadic market liquidity increases the risk of volatility spikes, but also of a monetary policy mistake, especially in light of a pivot that prematurely ended the attempt of returning to a traditional (normal) policy framework. We are therefore maintaining defensive and diversifying investments in portfolios.
Weakening growth and volatile market conditions in Q4 2018 motivated the US Federal Reserve to pivot at the beginning of the year. In Q4, the Fed Chair proclaimed that rates were “a long way from neutral” and the unwinding of the bank’s balance sheet was on autopilot. However, in early January he announced flexibility in the policy path in the form of data dependency. This shift was confirmed at the Fed’s March meeting, when 11 of 17 Fed officials projected no interest rate increases for the entire year. In December, most officials forecasted between one and three increases. The Fed also announced a slower pace of the balance sheet reduction, ending the process in September.
Subsequently, other Central Banks lined up behind the Fed: Chinese authorities declared a broad catalogue of monetary and fiscal stimulus, while the Bank of Japan revised its inflation forecast down and reaffirmed its commitment to target the 10-year yield. The European Central Bank launched a third Targeted Longer-Term Refinancing Operation and provided forward guidance of current rates through the end of 2019.
As a result of the shift by the Fed, financial conditions in the US eased in Q1 driven by rebounding stocks and the opening of credit markets of which parts had come to a standstill in December (Figure 1).
Figure 1: US Financial Conditions (Falling Graph Indicates Easing)
Source: Bloomberg, as of 12 April, 2019.
Given the easing of financial conditions, we believe near-term recession risks in the US are low. Man GLG’s leading indicator for the US ISM Manufacturing Index points indeed to a stabilisation of growth (Figure 2). The picture looks more fragile in Europe, which lacks any coherent reform initiative and is paralysed by the torturous Brexit process; however, global growth is likely to receive sufficient support by a rebound in the US and China.
Figure 2: GLG ISM Leading Indicator1
Source: Bloomberg, as of 12 April, 2019.
Another boost to this business cycle may come later from a possible shift by the Fed to average inflation targeting. This would enable the Fed to let inflation exceed 2% following a period where price levels stayed below this threshold. The consequences of allowing inflation to make up for undershooting the target could not only be an extension of the business cycle (because of the fall in real interest rates), but also asset bubbles and leverage excesses. It also creates the risk that when the Fed eventually hikes interest rates, it will overtighten financial conditions as the transmission mechanism of traditional monetary policy to financial markets has weakened due to the decline in market liquidity (and other factors). Market depth and liquidity in equity, fixed income and credit markets has fallen significantly since 2009. The risks from more fragile, illiquid markets were visible in December. The volatility-dampening function of liquidity provision has partially moved from traditional actors such as bank prop desks and value investors to Central Banks, which can only fulfil it as long as they are not forced to tighten, have tools available, and have the political support.
Brexit remains a tail risk for markets which could shock asset prices. Additional political risks come from trade. Expectations of a deal between the US and China are high (and hence largely priced in). A derailment would undermine investors’ renewed confidence. Following a closure of the China chapter, the next focus of US administration is likely Europe, where there is a perceived imbalance between trade and defence relationships. These negotiations could be another source of market volatility and be complicated by divergent interests within the EU.
In summary, we believe that economic fundamentals are likely to improve from the recent weakness. Market support from Central Banks was re-underwritten in Q1 and improves the picture for carry strategies. Risk assets incorporated the improved outlook quickly. Further support for growth could come later in the year from a possible shift to average inflation targeting. This increases the risks of asset bubbles and a policy mistake when the Fed eventually faces an inflation challenge. The resulting asset class volatility will be accelerated by limited market liquidity. We are therefore biased towards uncorrelated hedge fund strategies and have reduced exposure to directional managers.
The snap back of markets in Q1 benefited directional managers, both those that have persistent long exposures and more dynamic funds such as Trend Followers. We are underweight these strategies in favour of Relative Value strategies which we believe will generate higher alpha over time. We are excited about the quality of managers in advanced quantitative strategies and are therefore expanding our Statistical Arbitrage lineup. We are reducing the overweight to Event Arbitrage, as spreads have compressed and deal activity is falling. The outlook for Credit has improved, driven by reduced tail risk given the financial environment described above, rather than an expansion of the opportunity set. We have a revamped shortlist of niche Equity Long-Short managers operating in ways that we believe will be difficult for systematic strategies to replicate, and will potentially add some of them to the Approved List during the coming quarters.
Our portfolios maintain an overweight to Relative Value2 strategies. Within this sector, the area of highest conviction is Statistical Arbitrage where we have moved away from traditional fundamental quant and into managers using new techniques such as Machine Learning and Alternative Data. New techniques have broadly outperformed traditional techniques. We continue to find interesting opportunities here; however, it is difficult to assign a view to the overall universe of these managers, as they can vary considerably in quality. Larger managers (measured by resources as opposed to purely by assets under management) have persistently outperformed medium and smaller managers over the last few years, and we believe that these managers will increasingly capture a high proportion of available alpha. Where possible, we aim to find capacity in managers that are better resourced and have lower ‘cost of production’. However, we augment that approach by researching smaller managers with a unique and identifiable edge in order to capture capacity early and grow alongside the managers.
We are changing our outlook for Event Arbitrage from overweight to neutral. While market activity remains high, the uncertainty surrounding Brexit is causing a drop in European deals. Spreads have tightened following the market rebound. Some managers argue that the decline in hard catalyst trades is being compensated for by an increase in soft catalyst opportunities, however, we are mindful of the often poor risk reward and associated market beta of soft catalyst trades. We analysed the HFRX ED: Special Situations and HFRX ED: Merger Arbitrage indices as proxies for soft catalyst and merger arbitrage return streams, respectively. The beta of the HFRX Special Situations index to the MSCI World between January 2005 and March 2019 has been 0.4, compared to 0.1 for the HFRX ED: Merger Arbitrage index. The soft catalyst index has also had far larger tails than the hard catalyst M&A returns (Figure 3).
Figure 3: Histogram of Monthly Returns for M&A and Special Situations
Source: Bloomberg; Time period: January 2005 – February 2019.
We have a less favourable view on Fixed Income Relative Value compared to recent quarters, as fixed income volatility has declined (even considering the temporary increase in March) and the US rate hiking cycle is on pause. We believe the best opportunity is to gain exposure to this space as part of a diversified set of strategies, i.e. via multi-strategy managers with a Fixed Income Relative Value component.
At a strategy level, we have changed our outlook on credit from negative to neutral. We argued last quarter that the risk of adjustments in less liquid credit markets to the tightening regime justified a negative outlook. This is less of a concern today following the Fed’s pivot.
While there was a temporary opportunity from spread widening that occurred during Q4 2018, a large portion of this has since been retraced. However, our preference for Credit Long-Short over Distressed is based on credit spread levels that are still wider compared to the post-crisis tights two quarters ago, while the distressed universe remains small.
In Credit Long-Short, managers are focused on idiosyncratic credit selection and limiting credit market beta.
In Structured Credit, we see a balanced outlook after a prolonged period of positive performance supported by favourable technicals (strong demand for renewed yield for reach and limited supply) and solid fundamentals, which we expect to continue in the near term. Spreads across most sectors are off multi-year tights and managers’ loss-adjusted portfolio yields still look reasonable. Potential risks remain from higher rates as well as any economic surprises that upset the status quo.
In Convertible Arbitrage, we maintain that a sustained higher volatility environment will lead to a more attractive and robust opportunity set for the strategy, although elevated issuance may continue to pressure valuations in the near term.
In spite of a rather disconcerting trend of alpha dissipating over the last five years in Equity Long-Short, the factors driving this decay (too much capital, too many managers, high fees, etc.) are most impactful to managers that embody the typical large-cap, generalist profile. As such, we believe the best opportunities for alpha in Equity Long-Short lie in the niche pockets of sector specialist, small-cap managers, and those who can demonstrate a unique, sustainable edge that is not clearly under threat by the quant community or such aforementioned factors.
We have been reducing our directional Equity Long-Short allocation and revamped our shortlist, particularly filtering for US-based sector funds in areas with highly idiosyncratic sources of information or transformational qualities (i.e. healthcare, TMT) that could replace investments which have lagged expectations and do not demonstrate a sustainable value proposition going forward.
Many managers we interact with have a muted outlook on Equity Long-Short, with the view that an extension to the recovery of risk assets in 2019 would require meaningful progress with respect to growth and trade. Another risk to markets that is cited is the erosion of corporate confidence as a direct result of trade tensions, which has the evident knock-on effect of impacting capital expenditures and M&A activity.
We did not follow through with our plan to increase the exposure to Discretionary Macro with bias to developed market fixed income. Rates volatility collapsed at the beginning of the year, before rising again at the end of Q1 (Figure 4). A review of shortlisted managers left us without sufficient conviction to add additional funds to our Approved List. While Discretionary Macro funds may capture future asset volatility, we concluded that our portfolios are sufficiently uncorrelated and correctly positioned in a period of market stress.
Figure 4: Implied Volatility of 1-month Treasury Options (Move Index)
Source: Bloomberg, as of 23 April, 2019.
There has been no change in allocation to Managed Futures. We approach the space through three distinct areas: first, crisis protection type trend followers which include managers that cap equity exposure at zero or that trade short-term horizons. These managers tend to generate low Sharpe ratios, but have use for the specific mandates. Second, core trend funds which also have low Sharpe ratios, but high efficiency. We rationalised our Approved List in this space last year with a focus on fee and risk optimisation. The third area is high Sharpe ratio managers which have been able to protect their alpha by trading uncrowded assets. We have two core investments in this space and will seek to add additional complimentary managers.
We redeemed our sole Commodities manager in Q1, and while we maintain a handful of shortlist candidates that we view as being the most interesting in the space, we will not re-build an allocation at this time.
The capital efficiency of the allocation to Risk Premia remains an important feature for many of our portfolios. We have made use of the transparency that is available to us to make adjustments where necessary. After a brief period of relief, Value is underperforming again which has led us to reduce exposures to the factor. We will reverse this reduction when we see evidence that drivers of the influence (such as flow and concentration in certain sectors) are beginning to abate. To be clear, we do not attempt to time returns of style premia but intervene when drawdowns exceed our tolerance or macro factors justify an allocation adjustment.
1. Man US leading indicator constructed by the Man DNA team, expanding on work done by Cornerstone Macro.
2. We include Event, Fixed Income, Volatility and Statistical Arbitrage strategies when discussing Relative Value.
Opinions expressed are those of the author and may not be shared by all personnel of Man Group plc (‘Man’). These opinions are subject to change without notice, are for information purposes only and do not constitute an offer or invitation to make an investment in any financial instrument or in any product to which the Company and/or its affiliates provides investment advisory or any other financial services. Any organisations, financial instrument or products described in this material are mentioned for reference purposes only which should not be considered a recommendation for their purchase or sale. Neither the Company nor the authors shall be liable to any person for any action taken on the basis of the information provided. Some statements contained in this material concerning goals, strategies, outlook or other non-historical matters may be forward-looking statements and are based on current indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and the Company undertakes no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. The Company and/or its affiliates may or may not have a position in any financial instrument mentioned and may or may not be actively trading in any such securities. This material is proprietary information of the Company and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from the Company. The Company believes the content to be accurate. However accuracy is not warranted or guaranteed. The Company does not assume any liability in the case of incorrectly reported or incomplete information. Unless stated otherwise all information is provided by the Company. Past performance is not indicative of future results.