The unprecedented and eerie calm of the last two years was finally shattered in February by the sound of breaking glass in the volatility market. Of course, no one could really predict exactly when it was going to happen, but the market always tends to chase carry trades. As returns are eroded by the weight of capital, investors lever up their exposure until the carry is squeezed dry, and then some bright spark tries to get out. Historically it is at this point that it all gets ugly.
With the help of a nudge from the inflation data at the beginning of February, the Vix market acted out the narrative. The last of the carry disappeared at the end of January and the rest is history. Even the size of the move was unexceptional: the intra-day range of the Vix on the first Monday of February was similar to, for example, August 24, 2015. It was only if you measure the move on a close to close basis, that the move in February looks unusually large by historical standards. In other words, while you could complain about bad luck with the valuation level (at the day’s highs)… that’s about it in our view.
Everything else could have been a technical consequence of the position clearance in volatility – the sell-off in equities which in turn could have triggered the short lived rally in bonds. The reversal in prices caused trend followers to disgorge their January profits and to reduce risk from high levels. As the dust settles we have just two rueful thoughts.
First, why are our clever, innovative, complex, higher fee, alpha rich, quant hedge fund investments doing worse than the simpler factor capture type strategies this year? The cynics may look for an excuse to say it is the fees. But this effect can’t possibly explain the short run. In January there definitely were exceptional returns to both equity beta (which are probably over represented in the simpler managers and really should be discounted in this comparison) and to pure momentum trading.
In February, the story was different. The more complex managers have many more signals, more diversification and so for funds that trade at the same risk level as their simpler colleagues, they tend to run more exposure… more leverage, in some proportion to the greater sophistication. If volatility goes up beyond a certain point they may need to reduce exposure to manage risk and this could drive their positions into reverse. Since volatility tends to rise when markets fall, what might have looked like multi-dimensional alpha in good markets suddenly goes negative in bad markets and so looks just like beta just when you don’t want it. The curse is that you would probably rather have had the beta on the way up, and the benighted alpha turns beta-like on the way down: a loser both ways.
But this, fortunately, over simplifies. Most of the time, the higher alpha funds don’t have to sell down the risks as volatility moves higher – which is why it is identifiable as alpha in the first place. It’s just that this time the build-up of risk over the previous year ended with an event driven specifically by volatility.
We believe there is a lesson in here: diversification may not provide the safety net that some have claimed that it does. You might define the excess as the point at which the leverage it engenders forces the management of the risk into hyper-activity: it over-trades; tops and tails. It’s worth a thought when picking the managers.
The second issue that continues to intrigue is the USD. It was a muted participant in the February reversal and plumbed new lows by mid-month. While this spared the trend following community from a much worse fate, more importantly it likely may have impeded a wider contagion. A relatively weak USD operates as an important source of global liquidity across most risk assets. There is, for example, an uncannily tight relationship between the outperformance of EM vs DM and the weakness of the USD. The ostensive puzzle here is that with both expansive fiscal policy and tightening monetary policy one might naively expect a much stronger currency. In our view, this theory cuts no ice: for the first time since 2000, US 10-year yields are above even those of Australia and the USD is weak. On the hedge fund floors, the lack of conviction about why is really striking. Whether it’s to do with relative curve shapes, shifts in reserves or speculative positioning, foreign direct investment capital flows, or the scary twin deficits (fiscal and trade) it is not clear to us.
The great minds of money play a gloriously intense game but the rules are obscure and shifty. Lesson two, perhaps is a reminder that macro forecasting is hazardous and should be restricted to those rare points of clarity in which the balance of risks is clearly asymmetric.
Despite the higher volatility experienced in February, an environment of strong global economic growth, rising inflation and rates (both from very low levels) combined with a relatively weak USD is a powerful mix for risk assets, particularly those with a claim on growth and real assets (equities and commodities). But at what point does rising inflation become foe rather than friend of equity markets? When bond equity correlation turns positive, perhaps. With a remarkably flat risk curve (even inverted in the US), where bonds have a higher yield than equities, perhaps we are on the cusp of just such an asset allocation change. Sounds like something from the witches in Macbeth. And what did we just say about macro forecasting?
Hedge Fund performance in February has been quite mixed, with some more acute negative observations primarily in the quantitative space. Nonetheless, given the performance of underlying asset classes, the downside capture exhibited by most strategies was within expectations and in some cases rather encouraging.
Given the equity market volatility seen in the first half of the month, performance of Equity Long-Short hedge funds was decent. In particular, some European ELS managers made money from alpha and factor exposures, such as single-stock momentum which held up well through the market turbulence, to offset losses from beta exposures. In general, there was wider dispersion of returns than in previous months, which is not surprising given the increased market volatility. Managers generally reduced risk through the market sell-off (both net and gross), but only back to Q4 2017 levels, and in most cases risk remains elevated relative to the average of the last 12 months. Looking forward, managers remain largely bullish on equity markets, noting that the strength of GDP and earnings should be sufficient to carry equity markets to new highs despite fears over inflation and higher rates. However, all managers believe we should see a more volatile equity market landscape in 2018 as periodic shocks punctuate the return to more normal monetary policy.
Macro managers had mixed results and generally were able to maintain year-to-date performance in positive territory. Many benefited from the move higher in rates as they keep sizable exposure in rate payers as well as yield curve steepening trades. Some of the pro-risk positions that posted gains in January experienced a reversal early in February, particularly long equity exposure and long emerging markets currencies, with a moderate overall impact on performance. Inflation remains a key focus point as well as the relationship between interest rate differentials and the USD, which appears weaker than usual so far in this cycle.
CTAs experienced sharp drawdowns as their long equity positions suffered in the first half of the month while commodities and currency exposures added to losses. In commodities, losses originated from long exposures to energy as well as shorts in agriculture while in currencies the culprit was primarily a short USD stance. Exposures have been reduced meaningfully as expected, primarily in the long equity risk given the rise in volatility and the reversal in price action.
February was generally a positive month for Merger Arbitrage strategies. The first part of the month saw some widening in merger spreads, but there was not a sense of panic and managers opportunistically added to positions with enhanced risk reward characteristics. The second part of the month was strong as several large deals saw positive catalyst materialising. NXP benefited from Qualcomm’s increased offer and Sky traded up on news that Comcast is outbidding Fox. Relative Value strategies on the other hand had a poor second half of the month, with several spreads drifting further away from convergence. There was no specific driver but we sense some capitulation in that space. Managers remain upbeat about the opportunity set in Merger Arbitrage, with large deals progressing and corporate firepower at healthy levels.
It was generally a negative month for the corporate credit markets against the backdrop of higher equity market volatility and a backup in government bond yields. Leveraged loans outperformed high yield for another month as there was continued demand for floating rate risk resulting in inflows into loan funds while high yield bond funds saw heavy outflows. Longer-dated high yield as well as investment grade bonds lagged meaningfully given the selloff in rates. Structured Credit managers generally reported flat to positive returns as any spread widening was absorbed by the portfolio carry. Most securitised assets held up reasonably well during the early month’s volatility while there was some weakening in the synthetic CMBX indices which many managers use as a hedge against their long portfolios. The legacy RMBS sector was stable while there was some early month weakness in the higher beta credit risk transfer sector as well as modest widening for CLO BBs/BBB- bonds. The Puerto Rico muni bond complex continued to build on January gains as a revised fiscal plan submitted in February, unlike the January draft, included some cash available for debt service in the coming years. Corporate credit managers were flat to modestly negative, lower-rated and distressed credits mostly held up better than more liquid, on-the-run single name shorts and index hedges. Credit Long-Short managers outperformed outright Distressed managers as exposure to value and reorg equities had a negative impact on the latter.
Statistical arbitrage managers broadly posted negative performance. The worst impacted managers were clearly those trading futures strategies, both fast futures strategies and slower trend based strategies were large detractors. Interestingly, it seems that the more diversified managers weren’t any better than the generic trend strategies, on a volatility adjusted basis. Even within equity based strategies there was a pretty clear divergence between fundamental strategies and faster technical Statistical Arbitrage. Fundamental strategies were impacted by what seemed to be a moderate risk reduction in the space a few days after the moves in the broader index. Meanwhile technical Statistical Arbitrage strategies were largely unaffected. We would anticipate these strategies to outperform in a more volatile environment.