Q2 2025: Firmly on the Fence

1. Introduction

The first quarter raised far more questions than it gave answers. From a geopolitical perspective, the second Trump presidency has challenged the status quo around the nature of long-standing alliances and sacrosanctity of territorial sovereignty, without yet providing the promised paths to resolution of conflicts in Ukraine or the Middle East. From a fundamental perspective, economic data raised concerns around potentially weaker consumers, stickier inflation, and renewed recession fears. And from a technical perspective, markets suffered episodes of deleveraging in crowded names during late February and early March.

Against this backdrop, markets have been resilient. Dips have largely been bought, and outside of the underperformance of US tech names, equity indices are generally up on the year. In our view, equity markets remain expensive, and their levels do not reflect the multiple sources of uncertainty outlined above. Furthermore, credit markets remain well priced, with historically tight spreads and thus far relatively low levels of default despite the tighter monetary regime.

2. Our Outlook

We continue to be cautious. Hedge funds have performed well in the last few years, both in absolute terms and as a valuable diversifier to traditional asset classes. We have continued our theme of the last few quarters of downgrading strategies to neutral where we believe the opportunity for above-average returns is now lower, or where we believe the risk of losses due to unstable markets has increased.

We have downgraded our outlook for Structured Credit and for Market-Neutral Equity Long/Short from positive to neutral. In Structured Credit, the reduction reflects the recognition that spreads have tightened further across most market segments compared to recent quarters, while US consumer confidence data has rapidly weakened during Q1. In Market-Neutral Equity Long/Short, we acknowledge that, despite strong returns over the past few years, heightened geopolitical uncertainties could lead to more frequent episodes of deleveraging for the remainder of the year.

We maintain a positive outlook in two areas: Global Macro managers should be able to continue to navigate increased volatility across all asset classes, serving as a dynamic hedge against uncertainty. Additionally, we expect Micro Quantitative strategies to continue to perform strongly overall given expectations of prolonged higher rates and elevated levels of single stock volatility.

Figure 1 summarises our stance on different hedge fund strategies for Q2 2025.

Figure 1. Q2 2025 Outlook Versus Q1 2025 Outlook

3. The Details

3.1 Credit

We remain neutral on Credit Long/Short and Distressed assets. High yield spreads remain relatively tight despite some recent widening after hitting post-Global Financial Crisis (GFC) lows and dispersion has been normalising from relatively elevated levels. It is challenging to bet against lower-rated loans that might face fundamental difficulties if rates remain elevated. Financial conditions have been benign with easier market access. Lower-rated credits have outperformed over the past few months and continue to represent an area of idiosyncratic opportunities. Any sustained pickup in market volatility and/or technical selling could create attractive opportunities. Elevated defaults are expected for leveraged loans in a structurally higher interest rate environment. However, expectations have moderated as markets have rallied and capital market access has eased.

We remain neutral on Convertible Arbitrage as broad markets continue to trade close to fair value estimates and spreads for credit-sensitive convertible bonds that had lagged US high yield have compressed meaningfully. The success of the refinancing trade and recent strong returns have led to significant hedge fund interest in the asset class. We expect a more idiosyncratic opportunity set in credit-sensitive convertible bonds driven by name selection and engaging with issuers around liability management strategies. Persistently high volatility in equity and rates markets, driven by policy factors, is expected to benefit traditional volatility-focused convertible arbitrage strategies. After a slow start, primary markets will likely become more active, supported by significant global convertible bond maturities in 2025 and 2026. The key risks are a deep recession and meaningful pick-up in defaults or a significant uptick in net supply, as well as hedge fund deleveraging.

We are moving to a neutral stance on Structured Credit. Spreads across most sectors of securitised products have largely reversed the widening seen since the end of 2021. The increased volatility driven by the ongoing heightened geopolitical and economic uncertainty could eventually pose challenges. Overall consumer fundamentals are deteriorating, with potential headwinds that could significantly impact consumer sentiment, such as tariff-driven price shocks, job losses from government austerity measures, or the negative wealth effect from stock market losses. Loss-adjusted yields are still elevated, but, as expected, have been trending down as the Federal Reserve (Fed) has cut rates and spreads have narrowed. The primary risk is a substantial, widespread rise in delinquencies and defaults in residential and consumer asset-backed securities (ABS), driven by persistently high interest rates and significantly higher unemployment.

3.2 Quantitative Strategies

We’d like to remind readers that the broad outlook for quantitative strategies tends to vary less than for some other strategy categories, primarily due to their high diversification and lower reliance on market direction – a characteristic that can be seen as both a strength and a limitation.

Micro Quantitative strategies, which focus heavily on corporate instruments such as equities, are typically reliable sources of alpha, much like other relative-value strategies. This reliability has consistently attracted top-tier talent and managers, a trend that has persisted in recent years and continues to support credible capacity in 2025.

We maintain a positive outlook for our existing managers and the pipeline we see ahead, but also view the positive performance run of this sub-strategy bucket with both caution and optimism.

In our previous update, we highlighted that these strategies have performed well for several quarters, supported by the non-zero rate environment and stock volatility. However, we recognise that lower-turnover strategies have benefited from price momentum driven by the convergence of global earnings-to-price measures, which could leave them exposed to some give-back risk. Related to this, we saw some sensitivity to crowdedness in March when several multi-PM firms were reported to have reduced gross exposure abruptly and caused more than a ripple among equity market neutral performance – fortunately our holdings barely participated in this. We are a mindful that while we continue to encourage investors to invest with these managers, we also advocate balance in portfolios.

In Macro Quantitative strategies (i.e. quantitative approaches more focused on macro instruments like indices and rates), we maintain our neutral stance, but we are particularly wary of the business pressures we foresee on some managers in this sub-strategy peer group. Judging purely by returns and statistical outcomes, one might argue that the space is due a better 2025 after a difficult 2024. However, we can rarely be so myopic in quant since the themes we engage with are inherently longer term.

Our cautious stance stems from the fact that Macro Quantitative strategies typically exhibit relatively low Sharpe ratios, given their narrower instrument breadth compared to their Micro counterparts. Additionally, we see an abundance of higher Sharpe multi-asset quant capacity available in 2025, which is attractively priced and adds to the competitive landscape. This is likely to be viewed as more attractive than standalone Macro Quantitative strategies to investors, especially after they had a poor run of performance and because it is often viewed as a surrogate for hard-to-source liquid multi-strategy exposure.

We anticipate that this will push some Macro Quantitative managers to quickly move into the multi-asset quant space to bridge the gap. However, not all are likely to succeed – developing expertise in trading micro/equities is a significant undertaking and, in many cases, the very reason these managers intentionally avoided such expansion in the past. We see this as destabilising and therefore our approach will be to increase our selectivity, focusing on and concentrating with managers with specialised expertise who we believe can deliver both returns and diversification to our portfolios. That said, we believe that the best managers, i.e. those with the largest teams and highest pedigree of technology and research efforts, will be in a position to weather this period of disruption. They’ve done so previously and should remain compelling long-term investments.

3.3 Macro

We maintain our positive view on Global Macro strategies, expecting opportunities to arise across asset classes amid heightened policy uncertainty, differentiated economic outlooks and changing global trade patterns.

The new political regime in the US has widened the range of possible outcomes for markets, with trade policy in particular reshaping the outlook for the global economy. Global supply chains will likely recalibrate around tariffs and potential retaliatory measures, creating winners and losers as new relationships form between economies and existing ones weaken.

Central banks have a difficult task ahead of balancing risks to both growth and inflation, and it remains unclear how monetary policy will respond to supply shocks as economic activity slows. Meanwhile, disparate fiscal policy expectations can accelerate regional divergence, with Europe and China moving towards a more supportive stance while the US focuses on cost-cutting. As political and economic developments evolve, adaptable Global Macro strategies should find ample opportunity to capitalise on dispersion between economies.

3.4 Event Driven

We remain neutral on the outlook for Merger Arbitrage, given 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 desirable planning certainty that supports significant acquisitions. Nonetheless, the regulatory environment has normalised and become more predictable, though horizontal and Big Tech mergers may still face scrutiny. Spreads have tightened in recent months due to the closure of several high-spread transactions but have slightly widened more recently amid increased volatility and 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 amid 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 have downgraded to a neutral outlook for Market Neutral Equity Long/Short (ELS) while maintaining a neutral outlook for Long-Biased Equity Long/Short.

Structurally, a few factors discussed last quarter remain as potential tailwinds for fundamental ELS strategies. Single stock dispersion metrics remain heightened, while single stock correlations remain low. There has been heightened volatility this year and this is expected to persist amid policy uncertainty and ongoing geopolitical conflict. Interest rates remain elevated, posing challenges for companies dependent on capital markets for funding, while continuing to provide a tailwind from positive short rebates.

The rationale behind a less sanguine view stems primarily from the fact that equity markets have been driven more by top-down factors of late, somewhat paradoxically given the aforementioned uncertainties. Looking back to the most recent corporate earnings season in the US, reports were generally solid, yet there were still extreme sell-offs in non-earnings periods attributed to non-fundamental drivers. While most market outlooks heading into this year anticipated a pro-business stance from the Trump administration, corporate management teams have indicated that forecasting, managing cost structures, and setting investor expectations have become more challenging due to policy uncertainty. We see this as a potential headwind for fundamental investing styles.

More recently, there have been indications of funds venturing into non-core areas for returns (i.e., US funds increasingly investing in Europe). This is a market that has historically been viewed as less efficient and alpha rich. We're flagging this as the idea of ‘tourism’ presents something of a mixed bag, potentially leading to either alpha generation or degradation in these previously less efficient, alpha-rich segments.

Overall, this quarter’s view reflects a mixture of optimism around dispersion with pessimism around the drivers of single stock performance – which sounds a bit counterintuitive, but we have found that dispersion is just being captured over shorter trading windows. We continue to believe that maintaining a diversified – by geography, sector, and trading style – portfolio of specialist managers may continue to be an attractive way to generate a more stable return stream in the Equity Long/Short space.