Q4 2022: Alpha Through Risk Management

1. Introduction

In our Q3 outlook, we warned that the macro outlook remained challenging; we believe that this view has been validated over the past three months.

More than a decade of extreme monetary and fiscal policies has led to occasional extreme volatility in asset prices. But today we are seeing that markets are not only volatile; they are also fragile. This is best illustrated by the safest and most liquid instruments surprising investors with their sudden volatility, as UK government bonds did in September (prompting an emergency intervention by the central bank).

Figure 1. YTD Returns of FRM Peer Groups

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Source: Man FRM database of hedge funds; as of 31 August 2022. The returns of Macro Quant and Global Macro are normalised to have volatility equal to the average volatility of the other peer groups.

2. Our Outlook

2.1. Current Outlook

Figure 2 shows our stance on different hedge-fund strategies for the fourth quarter.

Figure 2. Q4 Outlook Versus Q3 Outlook

2.2. New and Notable

3. The Details

3.1. Relative Value Strategies

We continue to have a positive view of volatility arbitrage strategies with a net long vol bias, as these are well positioned to generate uncorrelated returns in the current dynamic volatility environments. Cross-asset strategies in particular can rotate into attractive tactical themes – and there are many potential geopolitical scenarios at the moment that could sustain or even accentuate volatility regimes.

We continue to maintain a neutral outlook for more opportunistic event-driven strategies. Although announced corporate events can offer attractive non-correlated return streams, longer-dated catalyst trades in particular are not immune to market directionality. There are certainly compelling pressures leading corporates to make their structures more efficient and unlock value potential, but catalysts materialise more predictably in more stable environments. This is particularly the case for softer catalysts. Our neutral outlook is also reflected in the lower observed exposure levels of investment managers, potentially awaiting better entry opportunities. Some growing opportunities include ADR arbitrage trades, which benefited from a US-China agreement in principle regarding accounting treatments, as well as other actively implemented relative-value trades in Asia.

Our neutral outlook on event-driven strategies is also supported by the environment for merger-arbitrage trades. We’re acutely aware that in this shorter-dated strategy both the opportunities and risks can fluctuate quite rapidly. We see this highlighted in merger spreads, which tightened during Q3 compared with the dislocated wides seen late in Q2. However, recently spreads have spiked again in response to market weakness. Deal completion risks are nevertheless often idiosyncratic, and currently there are attractive risk/reward opportunities in fairly priced transactions with strong strategic rationales. Deal flow is vital for merger arbitrage, and recent activity levels have been decent, particularly in the US. This flow is trending to smaller to mid-sized deals, while larger deals, often led by private equity and requiring significant debt raises, are under pressure from fast-rising rates. Antitrust sentiment continues to be a challenge for this space in multiple jurisdictions, but recently there have been encouraging deal approvals. Antitrust risks appear to be somewhat more predictable and priced in by the market, however.

Overall, while fragility has decreased since Q2, disappointing or unexpected developments around announced catalysts are often followed by contagion in related transactions. Conversely, calmer markets, successful deal closures, predictable regulators, wider spreads to reflect rising rates, and strengthening deal calendars would bolster these strategies. Disciplined, experienced and well researched investment managers with differentiated tactical trading opportunities should be well placed to benefit.

3.2 Quantitative Strategies

Looking further ahead, we are enthused by recent developments in China that will soon allow managers to trade futures more cost effectively and increase capacity. However, many systematic managers must still complete the required legal work to benefit from the changes.

Lastly, futile prospecting has moderated our entry into quantitative crypto funds and highlighted challenges in sourcing managers of institutional quality that also offer the best investment talent. Ultimately, we are confident this is an attractive new area, but we feel there is no great rush either. On the contrary, digital assets are increasingly being adopted by many of our managers at a sensible pace anyway. And rather than be heroic in what seems like a minefield of adverse selection today, we err on the side of patience. Our goal is to keep an active network and a keen eye for gems, while allowing nature to take its course and, through survival of the fittest, weed out some of the weaker players. Volatility in cryptocurrencies and the collapse of excessive leverage have likely accelerated this development.

3.3 Equity Long/Short

Our outlook on equity long/short (ELS) remains balanced. While lower equity valuations may eventually represent an attractive entry point, we do not think this is the time to make a beta bet. Rather, we feel that low beta and tactical ELS managers are more attractive against a backdrop of an uncertain macroeconomic climate.

We have previously noted decreased risk-taking across ELS funds and this trend has continued. At the high level, this can be seen in reduced gross and net exposure levels. Beneath that, portfolio composition suggests some hesitancy from ELS funds as well. Single-name turnover is low, with fewer new long positions being established during market selloffs. At the same time, there has been an uptick in index-level hedges relative to single-name shorts. We also note increased use of options and tail-risk hedges. Heading into Q4, managers are clearly focused on preserving capital rather than playing offence.

Given an uncertain economic climate and lower risk-taking, we view ELS as a form of mitigating downside risk rather than absolute return heading into the end of 2022.

3.4 Credit

Increased dispersion by credit ratings and across sectors is leading to an improvement in long/short high-yield opportunities. Similarly, credit long/short managers are increasingly seeking to take advantage of capital-structure arbitrage opportunities driven by dislocations between debt and equity in volatile markets. There is still a lack of substantial defaults in the US and, as a result, managers generally want to maintain dry powder in case defaults pick up or spreads widen materially. Managers with a global focus, though, are increasingly evaluating and selectively allocating to the sizeable universe of emerging-market distressed/defaulted sovereigns and corporates.

Overall convertible bond market valuations, while cheaper this year, have held up much better compared with the significant dislocation of Q1 2020. However, as we discussed last quarter, there has been a meaningful pickup in the universe of busted convertible bonds of growth and technology-oriented companies. These securities tend to be somewhat orphaned by traditional long-only as well as volatility-oriented convertible arbitrage managers. We like the event optionality and idiosyncratic opportunity set in these credit-sensitive convertible bonds. A recent pickup in exchanges and refinancing-driven new issuance has been positive and it is expected to be sustained as issuers look to address short-dated maturities.

Spreads across most securitised-products sectors are little changed to modestly tighter since our last quarterly update, but remain meaningfully wider since the beginning of the year. This, coupled with ongoing repricing higher of interest-rate curves, has resulted in some of the highest loss-adjusted portfolio yields for structured credit managers in the post-Covid period. Managers have been deploying incremental capital with increasingly attractive convexity, seeking to take advantage of opportunities across the credit curves, but remain mindful of the elevated market volatility.

While underlying consumer credit and residential fundamentals have largely remained stable in the US, there is increasing uncertainty and a softening is anticipated and modelled by managers. Rising mortgage rates have led to reduced housing affordability and demand, resulting in an expected decline in home prices next year. A gradual rise in delinquencies and losses is expected, but ongoing cashflows should remain robust given the credit enhancement and curing as well as reduced loan-to-value ratios for somewhat seasoned securities.

As such, we look to add risk opportunistically, but there is no change in our overall balanced outlook given:

1. The highly uncertain macroeconomic environment, and
2. Unlike previous dislocations, the opportunity set should persist for longer given the lack of central-bank support for risk assets.

3.5 Global Macro

Now, the focus has returned to pricing global policy paths against a difficult backdrop of stubbornly high inflation, economic slowdown, an energy crisis in Europe, and dwindling central-bank credibility, while the impact of quantitative tightening and changes to the fiscal outlook and government bond supply are expected to create opportunities in longer-maturity instruments. We are also seeing themes positioned around volatile current account deficits, de-globalisation, and developing expectations for mortgage rates and housing markets.