February 2024 - Balancing Euphoria and Diversification: The Hunt for Hedge Fund Alpha

Our role as hedge fund allocators requires us to look at markets through an unorthodox lens. We have long since abandoned any hope of predicting market direction, and instead focus on whether the market backdrop has presented, or is likely to present in the future, a fertile hunting ground for hedge fund alpha.

One of our key frustrations for much of last year was speaking to managers who were struggling to generate alpha and finding their explanations of the drivers of their difficulties to be a little weak. Outside of the regional banking crisis in March 2023, which led to sharp losses for some Macro strategies unprepared for the violent rally in bonds, there were relatively few headline reasons for weak alpha. And yet, once one correctly discounts for equity beta and credit spread beta, alpha was thin on the ground for much of 2023. It was surprisingly sparse across a range of strategies, rather than being concentrated in one area.

In counterpoint to this observation, in the first two months of this year alpha was present in a range of strategies and, in some cases, it has been quite abundant. The most common driver here is momentum, in both time series (i.e. trends in markets) and cross-sectional (i.e. securities performing well on a relative basis versus peers continuing to do so) forms.

Momentum loves a consistent narrative, and as scary as it feels sometimes, the prevalent present narrative we see is: ‘the economy is fine, the Fed has your back, so buy equities.’ Equity markets continued to rally strongly, with the S&P 500 passing recent peaks and the Nikkei 225 finally surpassing its previous high from way back in 1989. Retail investors are increasingly part of the mix. Bitcoin surged back above $60k on continued structural support for the crypto asset class, and the options premium spent on Nvidia stock last month was close to $3bn (given the frenzy around the Q4 earnings announcement), or over 20% of the total US single stock options premium spent in February.

And therein lies the hedge fund allocators biggest challenge. Returns are much stronger this year than last, which is a welcome development, but the momentum exposures which are leading the gains are becoming overextended and borderline euphoric. There’s nothing immediately on the macroeconomic agenda for the next few weeks that poses an obvious risk of changing the narrative, and so allocators must now sit with these uncomfortable markets, managing risk prudently, while trying not to kill the golden goose.

But return drivers that all start to correlate to equity market gains are not useful for the hedge fund industry in the long-term - we are supposed to diversify the returns to traditional assets after all. There are a few consolations to the current regime; hedging is cheap and therefore managers need not bear too much reversal risk, and the rally in momentum is leading to widening spreads in valuation between cheap and expensive stocks on a variety of value and quality metrics, potentially storing up interesting alpha opportunities for later in the year.

Key Drivers of Hedge Funds Performance: An Early February Snapshot

Equity Long-Short:

• February was largely a continuation from January, with ELS funds capitalising on strength in global equities for modest monthly gains. Alpha generation did not appear to be as strong as in January, with the average fund capturing about as much upside as net exposure levels would dictate.
• A strong rally in Chinese equities meant that Asian ELS fund performance picked up in February. Upside capture among this cohort funds has been diminished by both lower net exposure and managers maintaining a higher concentration in global equities.
• There was significant net buying of US tech stocks leading up to Nvidia’s earnings. Following the report and subsequent tech rally, ELS funds pivoted to heavy net sellers of US tech stocks – both through trimming gains and re-shorting stocks.
• In contrast to the U.S., there have been signs of higher dispersion and lower correlation across European stocks, which is encouraging for managers in the region.

Credit:

• It was a modestly positive month for Corporate Credit managers with relatively muted single name profit drivers against a backdrop of continued spread tightening in US High Yield, higher treasury yields, and active primary markets.
• Convertible bonds saw modest richening. Financial preferreds saw some intra-month volatility post- New York Community Bank (NYCB) earnings miss, with regional bank preferred securities finishing modestly lower on the month.
• Stressed/distressed credits were mostly positive contributors, and managers also made money on rate hedges while portfolio level credit hedges were a detractor.
• Positive returns for Structured Credit managers were largely driven by carry, with spreads largely unchanged on the month.

Event Driven:

• February returns in Event Driven were modestly positive.
• Asia has been a source of strong performance for some managers, with RV HoldCo/OpCo trading and Korean corporate governance themes noteworthy, as well as idiosyncratic Japan soft catalysts. The strong China recovery was a challenge for alpha short positions.
• Strong M&A deal activity in both US and Europe continues to bode well for the strategy, e.g. Capital One announced a $35 billion all-stock acquisition of Discover Financial Services. And in Europe, Novo Holdings made an unsolicited bid to buy Catalent ($10bn).
• The bidding war for Wincanton (a UK logistics company) is heating up, with US-based GXO Logistics topping an offer made by CEVA.
• The AbbVie buyout of ImmunoGen ($10bn deal) concluded ahead of schedule, closing a nice spread, leading to profits for many managers in the space.
• In terms of more negative catalysts, the Federal Trade Commission suing to block the Albertsons/Kroger merger was no great surprise to managers. The Hess/Chevron deal traded down after Exxon claimed some change of control rights on a major underlying asset, however, the industry sentiment is that this is unlikely to derail the deal.

Macro:

• February was a more difficult month for discretionary macro strategies. Longs in Euro rates have suffered losses, as have receiver positions in EM local rates.
• Japanese themes struggled with JGBs moving sideways and JPY selling off.
• In terms of the outlook, managers are now positioning for rate cuts being delayed until at least the second half of the year, and FX exposures are shifting – managers looking for opportunities to short higher-yielders where central banks look committed to delivering material rate cuts, as growth slows and inflation falls.
• On the other hand, trend strategies are performing well, as price trends have continued across commodities, which has helped alternative trend strategies in particular. Managers have built back into fixed income shorts to good effect, while US and Japanese equities continue to be profitable.

On the radar:

• With the Q4 earnings season largely completed, managers’ focus now turns back to fundamental data on inflation, jobs and economic growth. The balance between recession risks and inflation risks has implications across a variety of hedge fund exposures, not least whether the recent momentum rally continues.
• Longer term foci include the elections cycle in a number of countries, most notably the US in November. It remains harder than usual to discern the obvious winners and losers from either a Donald Trump or a Joe Biden success, and we are watching closely for a clear picture of how markets might react to either victor.
• Of more immediate political interest is if either candidate pulls out of the race between now and November. Given the primary caucuses are as good as finished now, the most likely route to a change in presidential candidates would be ill health, which cannot be ruled out as a possibility given the age of both men. Equally, given that most alternatives on both sides of the contest poll easily ahead of either incumbent, markets may react strongly to a change of candidates in expectation that the election is then a done deal.