Investment Strategy - Q3 2018

Following flat performance during a volatile Q1, hedge funds generated a modest gain in Q2. Year-to-date performance of the HFRI FOF Diversified Index through June 2018 was +0.9%. Markets continued to be unsettled in Q2, which led to disperse strategy and manager results.

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30 JUNE 2018

We expect localized episodes of volatility to continue to flare up. We believe financial markets are increasingly unstable as we transition to a new regime without virtually unlimited liquidity by Central Banks. This potentially increases the risks for global growth at a time when many risk assets in Developed Markets price in a continuation of the economic expansion.

We favor Relative Value strategies due to their non-directionality and ability to take advantage of dislocations. However, we need to test our assumptions on their resilience. We expect the environment for alpha generation to be challenging for Equity Long-Short, especially in the US. We maintain a preference for nimble managers that can tactically reposition portfolios.

Hedge fund performance review

With the backdrop of volatility rising across markets and asset classes in the first half of 2018, hedge funds were still able to generate modest positive returns. Year-to-date performance of the HFRI FOF Diversified Index through June 2018 was +0.9%. Hedge fund performance in Q1 was flat while equity markets experienced losses and volatility increased sharply. Markets continued to be unsettled in Q2, albeit with lower volatility in equity indices.Overall hedge funds generated a modest gain despite some strategies struggling.

Q2 was a mixed quarter for Equity Long-Short which experienced a roll-over of the momentum and size factors in April. The momentum reversal was particularily prevalent on the short side. European managers initially benefited from an outperformance of their markets due to the US Dollar rally. However, this reversed in May and June, despite the continued strengthening of the Dollar. Managers with a growth bias enjoyed renewed highs for technology stocks while value managers continued to face headwinds. US small cap stocks outperformed large caps over the quarter as they are less affected by protectionism and benefit from the strong US economy. Asian equity managers had a difficult quarter due to their weak local markets, particulary in popular technology stocks which suffered from the concern of an escalation of the trade dispute between China and the US.

Quantitative managers had a negative Q2 as June proved to be difficult with volatility of equity factors. Technical managers, which had positive performance in Q1, gave back part of their returns in Q2. The stabilization of trend following results that started in March continued in Q2 with gains in energy commodities but losses in a fixed income rally during May after concerns arose on the new Italian government’s commitment to the Euro currency union.

Credit managers had a solid Q2. At the beginning of the quarter, the lack of idiosyncratic return drivers kept returns modest, but with a number of corporates making progress towards the reorganization of their balance sheets and with re-listed equities rallying, credit returns picked up. Structured Credit continues to perform above expectations due to a combination of favorable technicals and fundamentals.

Event Arbitrage returns picked up in Q2 following the breakthrough between the US and China in the dispute around a Chinese technology company that had violated US sanctions. This was seen as a positive for completion of deals reliant on approvals by Chinese regulators. Also, a positive court ruling on a takeover of a media content company by a telecom firm led to gains and the subsequent closure of the deal allowed for capital to be redeployed in other corporate transactions.

Financial environment outlook

Our financial market outlook is that localized episodes of volatility will potentially continue to flare up and characterize an increasingly unstable environment under pressure from the drain of liquidity. This potentially increases the risks for global growth at a time when many risk assets in Developed Markets price in a continuation of the economic expansion.

Weakening growth at the end of Q1 challenged the optimistic outlook of continued strength in global economic activity in our view. However, we believe the picture brightened again during Q2, with indicators in the United States pointing to a return and a potential upswing. Despite the soft patch in Q1, we believe the last 12 months have been extraordinary for the global market economy: broadening and strengthening growth; decade low unemployment levels in a number of large countries; inflation moving towards target levels; and renewed optimism in the business community. The economic outlook is unusually positive for a late stage of the expansionary cycle but stems from confidence in muted price and wage pressures from demographics, underestimation of slack and the influence of globalization and technology.

What we believe remains worrying for the long-term outlook is that the expansion has been almost exclusively reliant on monetary policy which has created highly accommodative financial conditions. We believe policy makers should use the current growth window for structural reforms to reduce the economies’ dependence on easy money. In May, the Eurozone, and some Emerging Market countries once again provided an example of how quickly the risks of procrastinated structural adjustments can materialize in market stress that will test weak links if not contained.

Structural reforms that make labor and product markets more flexible could allow for higher growth without inflationary pressures, but the populist shift in Western democracies leaves a murky picture as to whether progress is to be expected or not.

We note that the Trump administration initially followed a traditional Republican framework by cutting red tape. The subsequent introduction of protectionist measures runs counter to a pro-market policy and constitutes a threat to the world economy,less so because of their impact, but rather due to the risk of further escalation which may initiate the gradual loss of hard won globalization benefits.

The situation in Europe is also unclear. In Italy for example, the new government combines what in a traditional sense would be described as far-left and far-right politics but neither side has defined a pro-market mandate.

We believe global financial markets are increasingly unbalanced and show similar signs of excess as witnessed before the Financial Crisis. Low interest rates have fueled an increase in global leverage, which is notable in the private sector of Emerging Markets. While the banking sector is expected to be more resilient than pre-2008, high debt and low interest rates have meant that both fiscal and monetary policies potentially have less room to counter a possible downturn today than they did a decade ago. The dependence of markets on the increasingly unsustainable conditions of the last five years was visible to us in the sudden deterioration of Emerging Markets when the US Dollar strengthened against other currencies. The resulting tightening of financial conditions had a severe impact on countries with weak current accounts and/or significant budget deficits, notably Argentina and Turkey.

We believe there are indicators that potential unwinds are taking place underneath the surface of relatively calm investment markets as the transition from Quantitative Easing to Quantitative Tightening continues. We are concerned by the apparent volatility of risk factors such as equity value and quality which add to a growing list of localized tail events that have occurred this year despite relative stability of the MSCI World Index and gains for the S&P 500 and Nasdaq. Valuations of risk assets appear to be stretched to us, leaving little room for adjustments of expectations and a fragmented market liquidity framework which comes with the potential risk of higher volatility. Even if economic growth does continue, much has been priced in, reducing, in our opinion, expectations of forward looking risk-adjusted returns.

In summary, while we believe the near-term macro-economic outlook remains positive, we think the risk of financial markets derailing economic growth is increasing. Market valuations continue to anticipate a strong economic backdrop and fragmented market structures may result in drastic price adjustments. Heightened sensitivity to political headlines is an indicator of the inherent instability that characterizes markets which are transitioning into a tightening regime after years of unprecedented monetary stimulus in our view.

Strategy outlook

Our market outlook tilts us to favor Relative Value strategies due to their non-directionality and potential ability to take advantage of dislocations. However, we need to test our assumptions on their resilience. Q2 has brought challenges to systematic strategies and we are concerned about sudden correlation shifts. We will continue to critically evaluate Equity Long-Short due to the challenging environment we expect for alpha generation without factor or beta support. Notwithstanding the headlines that high profile launches have captured, we favor, in general, smaller managers which we believe can better navigate markets with reduced depth, and we aim to continue to provide our investors access to differentiated investment talent.

Relative Value

We are modestly optimistic on Event Arbitrage. Merger activity remains robust and the number of large deals continues to increase. The tax reform adds to corporate cash which can potentially be deployed for acquisitions. We believe board room confidence to undertake deals is high. Against this positive backdrop, we believe regulatory risks have increased and geopolitical considerations could impact the likelihood of deal closures. The volatility that these risks create can offer potential opportunities for trading-oriented Event Arbitrage managers which we prefer over static ones.

Other Event Arbitrage strategies such as share class arbitrage have not performed as well as expected given the increase in volatility. We have reduced our return expectations as this catalyst, which could have led to reversion of spreads between interlinked securities, materialized without triggering the anticipated price moves.

Due to our view on valuations, we will continue to keep a minimum exposure to soft catalysts.

We are optimistic on the opportunity set in Fixed Income Relative Value and plan to increase allocations where appropriate based on the view that the transition towards tighter monetary conditions may create more opportunities. We have seen evidence of that in the past quarters.

Despite the difficult period that Statistical Arbitrage has been going through, we believe that the structural shift to quantitative investment strategies will continue. We are using the observations we have made in Q2 to critically review our manager line up. We anticipate new investments in Q3 where we have been able to secure limited capacity in managers with higher expected Sharpe ratio. We will reduce our investments with Equity managers who run fundamental models exposed to factor rotations.

Credit

On a strategy level, we have a neutral outlook on Credit. The big picture has not materially changed: well anchored credit spreads despite higher equity volatility and limited availability of stressed and distressed situations. However, we are encouraged by the idea-sourcing of our managers and believe that given the size of credit markets, interesting opportunities may continue to present themselves. Credit dispersion could pick up as the business cycle matures. We are focused on managers with limited beta to credit markets either through the structure of their portfolios or via trading skills.

The rally in structured credit and flatter credit curves reduces the compensation for negative convexity in structured credit. We are monitoring closely how managers adjust their books in reaction to this.

Equity Long-Short

We believe that the Equity Long-Short strategy in general faces a more challenging outlook for return generation without undue factor or market support. This is true in particular for managers active in more efficient markets such as US large caps. We are also worried about crowding, for example in US technology stocks. We believe that skilled managers can benefit from the higher equity market volatility but we require them to operate with sufficient understanding and management of the factor risks they run.

The geographical mix of our allocation reflects our preference for Equity Long-Short managers that are active in international markets. We are researching opportunities in Asian Equity Long-Short, where we believe we find more high quality managers which run their books with an alpha-focus and limited directionality.

While we have contained the directionality of our Equity Long-Short allocation, we will trim exposures if we identify risks that do not correspond with our market outlook.

Global Macro

We believe that higher inflation, higher interest rates and higher volatility present a potentially better opportunity set for Global Macro managers. The lack of capital efficiency and often high fee burden associated with these managers remain barriers to our allocation.

Macro funds with a relative value approach appear interesting to us, consistent with our view on Fixed Income Arbitrage, but we also investigate opportunities in other asset classes.

Emerging Markets have experienced stress in Q2 which may eventually lead to more opportunities going forward. We approach the strategy at this point with caution given the long-bias that many Emerging Market Macro managers have.

We do not attempt to time Managed Futures allocations but own them for their protective characteristics, as demonstrated through 2008. As seen through the first half of this year, transition periods can induce losses but positioning is adjusted quickly as new trends are established.

Overlays

Alternative Risk Premia continue to complement many of our portfolios cost and capital effectively. We have added the Quality program where appropriate. While we are not timing allocations to Alternative Risk Premia, we evaluate them in the context of a portfolio’s needs and the flexibility that they offer.

 

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