Man FRM Early View - November 2021

Over the last few decades one of the most successful approaches to actively managing risk in portfolios has been trend following – that is, to systematically reposition one’s asset class exposure in line with prevailing market sentiment and to cut risk quickly and change positions when situations change. The philosophy is compelling, since the approach often frees the investor from human emotions in periods of market volatility, and the idea of letting winners grow while cutting losing trades can lead to an attractive pay-off profile of sizable upside with limited downside. The empirical evidence is similarly compelling, with strong returns to trend-following strategies in the global financial crisis, and good returns through the unusual COVID stained markets of 2020 and 2021.

Trends in markets over the last few months have generally been reflective of inflation risks. But inflation shocks and more traditional ‘risk-off’ moves affect most asset classes outside equities in sometimes diametrically opposite ways. Inflation scares are bad for bonds, whereas a flight-to-quality is good for bonds. Inflation worries push people into commodities and other real assets, whereas a growth shock sees a retreat from raw materials. The US dollar reacts to whether investors feel the Fed will need to raise rates to manage inflation or cut rates to stimulate the economy in a crisis. In short, the risk management issue is one of managing the correlation structure between asset classes, specifically the correlation to equities.

This tension between the different kinds of risk in markets was all too apparent on the 26 November, when increased concerns around the Omicron variant of the coronavirus led to a market correction. The moves in traditional assets were larger than those usually seen in a single day, but hardly seismic. The S&P 500 index gave back most (but not all) of its November gains, and US 10-year bond yields dropped back to around 1.48%, a level seen just two weeks before. Even the USD10 per barrel drop in oil prices only took those markets back to a level seen in September. However, those trend following strategies that had gradually positioned to protect against an inflation shock generally suffered losses across all asset classes. The tool for risk management became a source of short-term losses.

The path from here is equally fraught with conflicting risks since the inflation concerns have not gone away. During the market noise on the 26 November, the president of the Atlanta Federal Reserve and FOMC voting member Raphael Bostic reiterated his openness to ‘accelerate the pace’ of the central bank’s tapering programme. On the same day, new jobless claims in the US hit the lowest level since 1969, suggesting an extremely tight labour market. Furthermore, power prices in Europe hit new record highs on unseasonably cold weather across the continent and continued high gas prices.

On the other hand, risks to growth from Covid-19 are higher than they have been for much of this year. Armchair epidemiology is of little use to anyone; so, we’ll refrain from speculating on the potential paths that the emergence of the Omicron variant may take, only to say that there are clearly paths where each of the main factors of transmission, severity and vaccine-avoidance are more troubling than with the delta variant. In these scenarios, markets and policymakers may find themselves once again trapped between worrying about inflation and worrying about growth.

Until we have more clarity it seems likely to us that active market participants will reduce risk, particularly around the less liquid markets of the December holiday season. Risk reduction was undoubtedly a big driver of the market moves towards the end of November, and therefore one of the more surprising characteristics of the last few days of the month was that traditional areas of fragility during periods of deleveraging emerged from the market volatility relatively unscathed. We shall be watching metrics such as average merger spreads, liquidity provision through statistical arbitrage, and basis trades in fixed income, for signs that a risk reductive mindset is spreading through other liquid strategies.

Hedge Funds

Returns to hedge fund strategies were, in aggregate, negative in November. The generally negative profile emerges from a distribution with some significant losers, such as systematic macro strategies, many small losers, such as most equity long-short and credit strategies, and any winners across the space being generally modest in size, such as some relative value strategies.

The equity long-short space had seen some net selling activity through the early part of November, as managers generally consolidated YTD gains, which helped to mitigate the worst of the losses associated with the market correction at the end of the month. However, from a thematic perspective, funds have been increasing positioning into the ‘reopening’ camp, with many prime brokers noting that ‘go outside’ stocks were being net bought, whereas ‘stay-at-home’ names were net sold. Funds have also generally rotated away from healthcare names over the past few weeks. Therefore, the factor rotation seen at the end of the month was generally challenging for this more recent positioning.

Returns for the month were further impacted by general underperformance of crowded names, particularly crowded longs, during the early part of November, leaving some fundamental equity long-short managers nursing losses well before the increase in volatility. Some managers looked to ‘buy-the-dip’ on the 26 and 29 November, however, hesitancy levels were higher than in previous market pull-backs this year due to the inherent uncertainty around the spread of the Omicron Covid-19 variant.

In credit, high yield bonds pulled back towards the end of the month on the risk-off moves, with loans and investment grade credit broadly flat on the month. Investor dynamics are generally quite muted, with small outflows from high yield towards the end of the month and low issuance, whereas loans supply has picked up and continues to see investor demand. One surprise in the end-of-month noise is that the high yield energy sector held up remarkably well (almost in line with the wider market) despite the significant fall in oil prices.

Hedge fund manager performance was also muted in credit strategies, with relatively few idiosyncratic performance drivers. Convertible bond valuations have held up well despite a pick-up in primary market activity and slightly weaker credit markets, with managers profiting from trading new issues and from gamma trading. Stub trading and SPAC trading were also small positive contributors to performance during the month, with limited contagion thus far from the wider risk-off move in liquid assets. Elsewhere, it was another month of modest returns for structured credit managers – interest income and paydowns offset by modest mark-to-market losses driven by higher new issuance in some sectors, as well as volatility in the rates markets.

In relative value, there were mixed returns across many strategies for November. Event arbitrage generally had a quiet month despite an uptick in deal activity in November. Merger spreads tightened a little, and generally there were few signs of contagion from other risk-off moves in the last week of the month. Globally, Asian relative value strategies were slightly weaker than those focused on Europe and the US. More generally, the regulatory landscape has become less conducive to arbitrage strategies over the last few weeks. The US Senate confirmed Jonathan Kanter to lead the Department of Justice antitrust division, and he is thought to take a tougher stance on monopolistic mergers. In addition, we have seen an overhaul of the takeover rules in the UK, and Spain has extended powers to prevent foreign takeovers for another year.

Statistical arbitrage strategies generally posted slightly positive returns for November, with largely benign performance during the market volatility of the last week of the month. Better performing strategies were found in the factor space, where Momentum factors outperformed for much of the month, and Quality factors saw strong gains during the market correction. Fundamental mean-reversion signals also enjoyed a positive month after a generally difficult period through the summer months.