Investment Strategy - Q4 2018
The benefit of diversification across hedge fund strategies was evident in Q3 as the HFRI FOF Diversified Index generated a 0.5% return despite mixed performance across strategies. This took year-to-date performance of the index through September 2018 to 1.3%. As in the previous quarter, credit managers outperformed on average liquid systematic strategies.
The policy responses to the Great Financial Crisis (‘GFC’) ten years ago have shaped the risks that markets face today. We believe that higher interest rates, political risks and low market liquidity have the potential to disrupt the status quo and are insufficiently priced into risk assets.
We are adding diverse sources of crisis alpha returns to our portfolios. Despite a mixed year so far, we continue to look for opportunities to add high quality Statistical Arbitrage managers and also remain positive on Event Arbitrage. Fixed Income Relative Value is another hedge fund strategy that we are optimistic on. We are negative on Credit due to limited opportunities. Equity Long-Short managers face structural challenges which increases the hurdle for initiating new investments.
Hedge fund performance review
Hedge funds posted a positive return in Q3 despite varied performance across strategies, with the HFRI FOF Diversified Index up 0.5%, bringing year-to-date performance through September 2018 to 1.3%. Strong US equity market outperformance and struggles in Emerging Markets were amongst the dominating themes throughout the quarter.
Q3 was mixed for Equity Long-Short managers amidst a period marked by strong US outperformance versus other regions through August. There were also discrepancies in sector performance – in particular related to technology stocks – which meant that performance differentials were driven more by beta to countries or sectors than it was from idiosyncratic stock performance. Value extended its challenging run of performance, and managers focused on this could not gain ground throughout the quarter. Asia continued to be a difficult market for Equity Long-Short managers, characterized by the impact of the Bank of Japan’s (‘BoJ’) equity purchases and a continued pullback in Chinese stocks due to concerns around economic weakness from tariffs and deleveraging.
Quantitative manager performance picked up from the middle of July through August but then pulled back in September. Technical managers led the rebound in the first half of the quarter but had mixed results in September. Fundamental managers struggled throughout the quarter especially those exposed to Emerging Markets where factor volatility was high. Futures strategies were positive as returns in August compensated for two weaker months in July and September.
Credit had a positive quarter. Global credit markets were strong in July, with Emerging Markets and European High Yield (‘HY’) outperforming US HY; however, this reversed in August as US leveraged credit benefited from new S&P highs and global markets contended with the increasing Emerging Markets weakness. Structured Credit performed positively due to a mix of carry and mark-to-market driven gains. Idiosyncratic investments continued to progress, driving returns in the corporate credit space.
Event Arbitrage had a solid Q3 with a focus on vertically integrated corporate transactions. One prominent deal closed, ending a two year bidding competition for a media company. 2018 remains on track to be one of the strongest years in recent history for deal activity.
Financial environment outlook
Our outlook of the financial environment is that higher interest rates, political events and lack of market liquidity are key risks for markets. We believe that the probability that these risks will trigger corrections is increasing. We will therefore adjust the positioning of our portfolios to be more protective and more prepared to take advantage of potential dislocations.
Ten years ago the worst crisis since the depression of the 1930s reached its peak and triggered a series of policy responses that have shaped today’s financial markets. The world economy is in a far better state today than it was in 2007-09. However, the measures taken to address the GFC will be difficult to unwind and are drivers of the risks that are building up today.
Central banks introduced unconventional policies such as negative rates, asset purchases and more explicit forward guidance. As a result of this expansionary monetary stance, valuations of risk assets have been pushed up. Central banks have far larger balance sheets today than before 2008, with the BoJ’s account for example expanding from 14% of GDP to 90%.
Other actions to counter the GFC included tightened banking regulations, resulting in better capitalized banks. Led by China with a 7% of GDP stimulus, fiscal policy acted in coordination within the G-20, amplifying the monetary stimulus. Public sector debt has increased sharply leaving less scope to enact countercyclical measures in the next downturn.
Productivity growth has fallen steadily, which has been a factor of falling unemployment after the recession despite only a modest recovery impairing economies’ growth potential. Temporary effects such as support of labor markets by the public sectors immediately following the GFC were initially amongst the drivers of the falling productivity growth. However, we suspect that capital misallocations due to monetary incentives by Central Banks are another factor with long-term impact.
Quantitative Easing and low interest rates have benefited owners of risk assets; inequality is rising, which has fueled populism in Western democracies as there is widespread dissatisfaction with a system that is seen as rewarding a small, global elite while many bear only the risks.
With economic activity having finally picked up pace after many years of sluggish recovery post the GFC, the question is why one should be worried today? Firstly, high valuations of risk assets result in low return expectations for the future (bar a breakthrough in productivity or higher growth potential). The deficit funded US tax reform has added to borrowing from the future by providing a short-term boost. Secondly, there are a number of market developments that could derail economic growth (rather than the reverse causality of a decline in growth leading to a market sell off). Three risks are particularly relevant:
- Interest rates. The risk of an inflation surprise has increased with labor market tightening, wage growth, higher oil prices and the risk of a full blown trade war. The likely result would be a sharp interest rate rise which would trigger a re-pricing of risk assets (higher discount rate).
The asymmetric unwinding of global monetary stimulus has been a driver behind the US dollar strength which has weakened sentiment towards Emerging Markets and contrasts with the accommodating financial conditions in Developed Markets. While the dollar’s appreciation versus Developed Market currencies has petered out in Q3, Emerging Market foreign exchange has continued to lose value. The effects on dollar borrowers will be felt over the coming quarters in our view.
The markets’ confidence in Central Banks’ ability to manage these challenges appears very high following the recovery from the GFC. We believe that this adds to the risk of a policy mistake.
- Political risks. Populism manifests itself in two different risks: First, the “reject[ion] of globalism”, as described by US President Trump’s September address to the UN General Assembly, could lead to market disruptions if protectionism ends in a trade war. The weakening of multilateral organizations can hamper coordination which played an important role in addressing the GFC.
Second, political risks are rising in the Eurozone. Unlike in 2012 when parties mostly committed to the European project dominated the political landscape, populist governments (or the pressure from rising populist opposition parties) are less likely to continue the necessary integration to increase the Eurozone’s stress resistance. The barriers for any member to leave the Euro are of course still very high, but the risks of markets re-testing Europe’s commitment are increasing. How Germany would react to this is a valid question as its weakened chancellor is unlikely to be able to lead the country to a full fiscal union that would be necessary to close the fault of the Euro.
- Liquidity. The lack of liquidity increases market risks as insufficient liquidity provision can result in sharp corrections. Improving the safety of the banking sector has limited its ability (and willingness) to provide liquidity. This is now provided from fragmented sources and market depth is shallow when volatility increases as seen in February of this year. Market dynamics have also changed, with allocations shifting from active to passive and a higher proportion of systematic investment strategies. Volatility has not seen a sustained pick up, but until recently all major Central Banks themselves had been large liquidity providers, purchasing ca. USD 10tn of assets, and thereby depressing volatility. Financial conditions in the US have remained accommodative despite the stronger dollar, modest reduction of the Fed’s balance sheet and eight US interest rate increases.
Combined, these are material risks for financial markets which lead us to a more protective stance in portfolios. Clearly, the idea is not to hedge all risks, but to calibrate risks appropriately in accordance with investors’ needs. While a lot of progress has been made since the GFC, we are worried about the conditions that the unsustainable reliance on monetary and credit expansions have created.
In summary, while Developed Market economies enjoy growth and corporate earnings are at records, we believe that this is fully reflected in asset prices, different to risks that stem from interventions that were necessary to restore financial and economic stability. Therefore, we will add to strategies that are uncorrelated to markets and that can potentially take advantage of volatility.
We have identified risks which have the potential to challenge the status quo of low volatility across asset classes. Our portfolios have a strong focus on alpha and therefore carry limited market directionality. However, we believe that we can improve them by adding additional strategies which may generate value in market turmoil.
We are researching managers active in strategies that exhibit an attractive crisis alpha profile. We are focusing on the trade-off between expected returns through time and reliability of the protection during crisis periods. The desired return profile is most likely to be achieved by a combination of implementations across styles rather than a single solution. We categorize between tail protection, defensive and diversifying managers. Tail protection has the highest reliability of protection but exhibits negative carry in normal market conditions. Defensive managers exhibit protective properties with dispersion and uncertainty at modestly positive expected return and low Sharpe ratios. Diversifiers have higher expected returns which help pay for tail protection, but limited protective properties. Considering opportunities across the spectrum is essential to the completeness of a crisis alpha solution.
Given our market views we are overweight Relative Value. We challenged this view with the question whether the leverage that is often necessary to run the strategy is a risk that we still want to be exposed to. The increased stability of the banking system provides us with sufficient comfort to support our strategy preference. However, we will continue to manage appropriate gross exposure levels and monitor market indicators for stress.
The sub-strategy that the leverage discussion is arguably most relevant for is Fixed Income Relative Value. We have sourced additional funds based on the view that the transition towards tighter monetary conditions will create more opportunities and that we can identify managers with a risk framework that corresponds with our tolerance.
Statistical Arbitrage has faced a challenging environment this year, especially traditional factor models. We have been upgrading our approved list as we believe the long-term opportunity set is driven by a secular shift towards Machine Learning, alternative markets and alternative data. Hence, we have shifted allocations away from traditional Equity Market Neutral strategies whose Sharpe ratios have deteriorated. We have also incorporated in our decisions to what extent our managers are willing and able to advance their investment techniques to the next level. Following this re-underwriting of our managers, we plan to increase the allocation to quant managers.
We are optimistic on the opportunity set in Event Driven. M&A volume continues to ramp up and is on track to finish as one of the best years ever, driven by large transactions. Hostile deal situations have also seen a rise. Due to volatility arising from geopolitical and regulatory risks we have a tilt towards trading-oriented managers and will maintain limited exposure to soft catalysts. Position management was important last quarter when a prominent break resulted in wide deviations in managers’ results.
Anticipated periods of higher volatility will be beneficial for other arbitrage strategies. We have initiated a research project which may lead us to add to the space. Our focus lies on regions with less efficient capital markets.
Our overall outlook on the Credit strategy has shifted from neutral to negative. While we have high conviction in our bottom up selection, the limitations of the opportunity set and the risks of locking up capital weigh negatively on the allocation to the strategy.
We have a preference for Credit Long-Short over Distressed given tight credit spreads and low default rates. Credit Long-Short managers remain focused on idiosyncratic sources of return with an eye towards capital preservation and limiting credit market beta until the opportunity set improves, which suits our portfolios better than long-biased distressed and structured credit funds which we will reduce to monetize gains.
We believe there is an improving case for Convertible Arbitrage. Higher rates, higher volatility and an environment supportive of new issuance and gamma trading opportunities are positive factors that justify adding to this strategy which has been neglected for a long-time.
Structured Credit has had a prolonged period of positive returns supported by favorable demand and supply tailwinds and strong fundamentals. However, with potential risks arising from higher rates we plan to reduce our allocation further.
We have seen disappointing performance from Equity Long-Short this year. Fundamental value investing remains challenged. The US was the only region to benefit from beta exposure while all other regions have been negative year to date. Sector selection was important: Healthcare proved to be the best sector for alpha. We have been underweight the crowded, but rallying tech sector. We believe that our manager list has the potential to add value in a pull-back given our focus on non-directional funds.
We plan to expand our Asian exposure and are searching for niche strategies in the US. As we have discussed last quarter, we expect US markets to be a challenging environment for Equity hedge funds, we are investigating areas which have a higher potential for alpha. This could be smaller capitalization than targeted by systematic traders or niche sectors. However, given the opportunities we see in Relative Value, we will reallocate capital within Equity Long-Short rather than expand its weight.
Our Managed Account technology is an important tool to build an optimal investment proposition as it allows us to use capital efficiently and to control beta and risk factors across our Equity Long-Short exposures.
We have a mixed view on Global Macro differentiated between its sub strategies. Discretionary Macro could see an uptick in performance from higher inflation, higher rates and higher volatility. However, structurally this strategy can be difficult to access in an efficient way due to capital inefficiencies and excessive fee burden.
As discussed above, we are positive on Fixed Income Arbitrage which is a cross-section of Global Macro and Relative Value. The lack of capital efficiency can be a hurdle too but Fixed Income Relative Value has often a higher Sharpe ratio than Discretionary Macro. The higher Sharpe ratio comes with a trade-off though: negative skew. We have to have sufficient conviction in the stability of the underlying funding of fixed income managers.
We are hesitant to add to our minimal Commodity allocation due to the high failure rate of Funds. We have adjusted our existing position sizes for expected higher volatility.
Emerging Markets had a challenging environment in Q3 with crises in fragile Emerging Market countries such as Argentina and Turkey. In the last three months, we have seen mixed performance from Emerging Markets Macro. We will reduce our exposure as we have seen limited ability of trading-oriented managers to profit from the volatility and are hesitant to add directional risk.
We do not time trend following but use its favorable characteristics as tools for portfolio construction. With that in mind, we have made steps to improve the efficiency of our implementation which has resulted in a reduction in the number of managers. Where appropriate, we have reduced leverage to adjust the balance between capital efficiency and appropriate risk levels.
Alternative Risk Premia continues to complement many of our portfolios’ cost and capital effectively in our view. The recent period of volatility in risk premia has strengthened our confidence in our Alternative Risk Premia allocation based on the achieved results. We will continue to manage Overlays on a portfolio-specific basis in line with their mandates.
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