Q3 2025: Patience Pays

1. Introduction

The second quarter of 2025 began with the ‘Liberation Day’ announcement of tariffs on all trading partners of the United States, triggering widespread market volatility, and concluded with an escalation of the conflict between Iran and Israel, with the US becoming actively involved following strikes on Iranian nuclear infrastructure.

It is therefore somewhat surprising that equity markets (and risk assets more broadly) performed so strongly over the three months, with the S&P 500 rising 10.6%, the Nasdaq index gaining 17.7%, and high yield credit spreads tightening by approximately 60 basis points during the quarter.

Markets are rewarding the resolution of geopolitical and economic tensions more than they are penalising the disruptions that caused them. For all its apparent faults, the current market sentiment towards the Trump administration is one of support. The prevailing view appears to be that he is getting things done, regardless of the unorthodox methods employed.

In our view, there is a broader theme of market exuberance that extends beyond the political backdrop. The most crowded long positions held by hedge funds, as measured by the Morgan Stanley Crowded Longs Index, increased by 32.3% during the second quarter, with factors such as high beta, high volatility, growth, and momentum delivering outsized returns over the period. These extreme moves over such a short timeframe are indicative of flow-driven, frothy markets, particularly as fundamental data releases on growth, inflation, and employment have remained largely uneventful.

Against such unpredictable markets, it feels foolish to make predictions about the road ahead. Perhaps the best one can do is to expect that the unpredictability will continue for as long as we have such an unconventional backdrop to trade and geopolitics.

2. Our Outlook

In the outlook table below, many strategies are labelled as ‘Neutral’. This reflects both uncertainty about the future and our belief that opportunities will emerge in certain areas of the hedge fund industry over the next six to 12 months. We believe patience in waiting for these dislocations is a better approach than attempting to predict them in advance. As highlighted in previous quarters, we have emphasised the importance of remaining liquid and nimble in markets like these, and we continue to subscribe to this credo more than ever.

From a strategy perspective, the only change we have made compared to last quarter is to downgrade the outlook for Distressed Credit. This serves primarily as a ‘note-to-self’ to avoid being too early in the default cycle. Credit spreads tightened in the second quarter after widening in the first, while default and recovery metrics remain muted. We have maintained our positive outlook for both Global Macro and Micro Quantitative strategies. We anticipate Global Macro may continue to perform well amid the persistently volatile macroeconomic backdrop, while Micro Quantitative strategies could benefit from elevated interest rates and higher levels of single-stock volatility.

Figure 1 summarises our stance on different hedge-fund strategies for Q3 2025.

Figure 1. Q3 2025 Outlook Versus Q2 2025 Outlook

3. The Details

3.1 Credit

We remain neutral on Credit Long/Short and are turning tactically negative on Distressed. High yield spreads are modestly wider year-to-date but remain historically tight. On the positive side, market volatility has increased dispersion, with lower-rated credits underperforming. However, expressing short positions in lower-quality loans that may face fundamental challenges if interest rates remain elevated is challenging. Financial conditions overall have been benign, with higher-quality names enjoying easier market access. Lower-rated credits, meanwhile, present a niche for idiosyncratic opportunities.

A more sustained period of market volatility and/or technical selling could create attractive opportunities. Capital Structure Arbitrage and Convertible Bonds are focus areas for many Credit Long/Short managers. We find the risk/reward for taking on significant credit risk unattractive at current credit spread levels, which underpins our negative near-term view on Distressed Credit. While distress and default metrics in levered credit markets remain relatively muted, elevated defaults and liability management exercises are anticipated in a structurally higher interest rate environment. A deep recession and/or a meaningful pick-up in defaults/fallen angels could pose challenges for credit markets.

We remain neutral on Convertible Arbitrage. Convertible bonds have cheapened modestly over the past few months, but broad markets continue to trade close to estimates of fair value and spreads for credit-sensitive converts remain near historical lows. Hedge funds continue to make up the majority of the holder base, heightening the risk of a deleveraging event. We anticipate a more idiosyncratic opportunity set in credit-sensitive convertible bonds, driven by targeted name selection and engagement with issuers on liability management transactions. Elevated policy-driven volatility in equity and rates markets should support traditional volatility-oriented convertible arbitrage strategies. Primary markets are expected to remain active, underpinned by pending 2025/2026 maturities. Key risks include a deep recession, which could lead to significantly wider spreads and a meaningful increase in defaults, as well as a notable uptick in net supply and hedge fund deleveraging.

We remain neutral on Structured Credit. Spreads across most securitised product sectors have widened modestly in recent months, with collateralised loan obligations (CLOs) and commercial mortgage-backed securities (CMBS) underperforming. We continue to believe that ongoing heightened geopolitical and economic uncertainty resulting in increased volatility could eventually pose challenges for the space. While overall consumer credit and household balance sheets remain robust for now, there are ongoing headwinds that could meaningfully impact consumer sentiment. Loss-adjusted yields are still elevated but are expected to trend down as the Federal Reserve cuts rates. The key risk is a significant, broad-based increase in residential and consumer asset-backed securities (ABS) delinquencies and defaults, driven by persistently elevated interest rates and substantially higher unemployment.

3.2 Quantitative Strategies

We maintain our positive stance on Micro-Quant strategies, noting that the strategy has performed relatively well for an extended period – arguably since the end of the low-interest rate cycle. Current and ongoing opportunities in this space are now more typical and select, and largely driven by manager specifics rather than themes. That said, we think two interesting positive macro themes remain:

1. The positive impact AI and Generative AI are having on the success of managers’ strategies and especially in R&D. Anecdotally, it seems that increased use and understanding of these technologies is creating net gains for all quant managers, especially in Micro-Quant
2. The rising use of separately managed accounts (SMAs). In the past, SMAs in Micro-Quant were notoriously difficult to source. It’s still not easy, but attitudes have shifted under pressure from multi-strategy firms, and this has opened a door to finding more capital efficient solutions and more control over leverage levels

We maintain our neutral stance on Macro-Quant strategies. Over recent quarterly strategy reviews we’ve noted that these managers may struggle to achieve investor support when juxtaposed against the numerous multi-asset quant offerings available. We stand by this view and note that the year-to-date weakness of trend strategies has hardly helped these managers (since many Quant Macro managers inevitably have some exposure to trend). For us, this is a bit of a double-edged sword. We believe it makes canonical approaches less appealing, but it opens other doors and allows us to target specific sub-strategies and specialisms within Macro-Quant and use them more deliberately to enhance our portfolios. Our focus here is on commodities, digital and fast(er) futures strategies.

3.3 Macro

We remain positive on Global Macro strategies, anticipating opportunities may arise from divergent economic outlooks.

Cuts are priced in most global rates curves. However, disparities remain in the expected magnitude and timing of easing across regions. The Trump administration’s multilateral approach to tariff setting could amplify dispersion in economic conditions, likely necessitating distinct policy responses. Meanwhile, a renewed emphasis on fiscal sustainability may create cross-country opportunities as investors adjust regional exposures to evolving preferences.

With many macro narratives currently at play and more binary risk to positioning given a greater influence of political factors in markets, Global Macro managers have adopted a more tactical approach to trading this year. However, changing global trade patterns, persistent differences in rates and economic outlooks and a growing tendency to penalise fiscal fragility can catalyse more durable market themes, creating an attractive environment for macro investing.

3.4 Event Driven

We remain neutral on the outlook for Merger Arbitrage in response to the current economic uncertainty. While deal activity has been steady over recent months, particularly in the mid-cap space, the hyped expectations of an M&A bonanza under the Trump administration have not yet materialised. Unclear tariff impacts, more volatile markets and recessionary concerns undermine the planning certainty that support significant acquisitions. Nonetheless, the regulatory environment has normalised and become more predictable, though horizontal and big-tech mergers may still face scrutiny. Spreads have been tightening in recent months, as some high-spread transactions have closed, but have recently ticked a bit wider following the increased volatility and some controlled unwinds.

European opportunities may continue to grow as the region pushes for growth and consolidation. In Asia, Japan shows strong potential, driven by activism, pent-up demand, and value creation opportunities. Activism campaigns have increased globally, and the growing pressures in private equity to exit investments should also continue to support M&A. Overall, merger arbitrage continues to deliver a market-neutral profile, an attractive offset to a more volatile environment.

The outlook for wider Event Driven strategies remains neutral in our view, with opportunities driven by policy shifts, dispersion, and thematic catalysts like defence and infrastructure spending. These disruptions open new bottom-up opportunities, but catalyst conviction remains key. Refinancing challenges are creating stressed restructuring and capital structure arbitrage opportunities, helped by security price dispersion. Conversely, equity special situations face headwinds from uncertainty, requiring bottom-up conviction and tight hedges to avoid directional drift.

Pre-event positioning and index rebalancing become more challenging. In Asia, regional opportunities include share class arbitrage amidst volatile spreads, Japan’s corporate governance reforms boosting buybacks and profitability, and Korea’s “Value-Up” initiatives accelerating corporate governance improvements. A recovery in equity capital markets, maybe led by China, is a potential wildcard. Generally, while dispersion and region-specific trends create attractive niches, macro uncertainties continue to weigh on broader event-driven strategies.

3.5 Equity Long/Short

We are maintaining a neutral outlook for Equity Long/Short with a bias towards low net/market neutral over long-biased equity. Our neutral stance is reflective of a more constructive – yet moderated – view for stock-picking versus beta over the short term.

Positively, single stock dispersion metrics remain above average. While there have been short bouts of tighter correlation, we note that dispersion around corporate earnings is still heightened, and tariffs have created gaps between stocks in the same industry. We remain favourable on the potential for continued dispersion for a few reasons. First, countries are adopting varying fiscal and monetary policies. Second, while tariff risk is a more well-known factor, there may very well still be companies unable to cope with disrupted and/or changing supply chains. Finally, interest rates remain elevated which should continue to challenge companies reliant on raising additional funding via capital markets.

Gross exposures remain elevated in the Equity Long/Short space. There has also been an uptick in single stock activity, suggesting managers are more comfortable holding idiosyncratic risk. This contrasts with the previous quarter, when gross exposures remained elevated but were largely driven by index and exchange-traded fund (ETF) usage, particularly on the short side.

However, a few factors lead to a more balanced view on Equity Long/Short. First, equity markets remain increasingly thematic and top-down factors continue to drive the overall direction of markets. Investing in mega-themes can be a driver of alpha; however, we note that sometimes the euphoria around themes drives a “rising tide lifts all boats” situation, meaning short opportunities in fundamentally weaker companies are harder to come by. Additionally, the risk of style factor reversals has heightened as the amount of capital sitting in similar, tight factor constrained models has proliferated. Finally, the noise around tariffs has weakened business optimism and may lead to lesser correlation between first-quarter corporate earnings and those later in the year. A break in trends could hurt more momentum-oriented strategies.