Man FRM Early View - August 2022

Hedge fund managers enjoyed positive returns in August, during a volatile month in markets.

Alan Greenspan established the Federal Reserve put in the 1980s, giving a green light to the moral hazard that has brought us Long-Term Capital Management and Countrywide. Jay Powell retired the Fed put in November 2021. The market has been calling his bluff this summer, setting us up for an interesting rest of the year. As we are watching this, it is a good moment to take stock of how we got here, as well as what investment strategies have worked and what hasn’t so far this year. There may be some lessons that help us navigate the months ahead. For the Fed put to be effective, the market required a steadily increasing dose of stimulus, culminating in the massive, coordinated global Covid recovery sugar high of the last two years. While each intervention was individually justified (and some may have been initially too timid – the lack of fiscal support post GFC due to the hasty shift to austerity), in aggregate they have led us into a difficult position. The biggest deficiency of the academics that dominate Central Banks has been the complacency about the consequences of their actions. In 2017, Janet Yellen commented that unwinding the Fed’s bloated balance sheet – then less than half of today’s size – is like “watching paint dry”.
  
Supporting markets and the economy through ‘money printing’ isn’t a free lunch. The expectation was that the trade-off would be lower productivity and therefore lower expected real returns on risk assets. This was preferable over the financial, economic and social pain that market crashes would otherwise have caused. Limiting their frequency and depths by more humble, restrictive, and steadier money policy would have been even better.
 
When serial numbers and acronym soups were necessary to keep count of Fed and ECB programs after the GFC, critique of overdoing it arose. But market calamity didn’t occur and inflation remained mostly a textbook concept, which fed the confidence of Central Bankers. So there wasn’t any hesitation or doubt of what was needed when markets tanked in 2020. Policy makers pushed the envelop further. A crisis isn’t the time to reflect on what role the pro-cyclical banking regulation has played in the March 2020 sell-off. 

Central Bankers don’t look so smart anymore.  The first half of this year has left traditional 60/40 portfolios in trouble. Jay Powell said in June that “we now understand better how little we understand about inflation”, a truly remarkable statement on many levels. But most pertinent for investors is the trouble it spells for the traditional long equity, long bonds portfolio. Have hedge funds been able to deliver the diversification so far this year that could continue to be valuable in this environment of universal uncertainty? 

The short answer is: yes. But it comes with an important qualifier – which explains why the mood isn’t all marvelous amongst hedge fund managers and their investors: Hedge fund portfolios that were constructed with the aim of generating alpha and diversification have indeed delivered. That means: sufficient allocations to strategies which have a proven track record to be defensive. Naturally, that is inconsistent with benchmarking hedge funds against equities. However, if hedge funds were used to amplify or beat the return of stocks, investors have simply added to the pain from their equity holdings.

Strategies that have provided alpha were first and foremost trend following and discretionary macro. This is no surprise as these strategies have historically shown their diversification benefits in previous crises. Both were well positioned for the sell off in bonds and equities, and the rallies in commodities and the US Dollar. Clearly, both strategies have had spells of mediocre returns – but one should look at them holistically, in the portfolio context, rather than on a stand alone basis. The capital efficiency and capacity of trend strategies make them an especially useful tool for portfolios.
 
Trend Followers weren’t the only systematic strategy that worked. Systematic Macro funds were often aligned in their positioning with Trend managers. Quantitative Equity Funds benefited from the positive returns of value and momentum models, whose correlation turned – unusually - positive. It was therefore the Equity Market Neutral cohort relying on traditional signals that outperformed Statistical Arbitrage funds. But diversified systematic strategies, from high octane hedge funds, through to more liquid Risk premia strategies delivered on the mandate of diversification.

On the other end of the ledger were discretionary Equity Long-Short funds. This is a very large universe, within which, results varied widely. But it was US growth funds that dominated headlines – and some investors’ returns. Unfortunately, these managers tend to be amongst the largest in their peer group. These funds had enjoyed excellent results in 2020 through concentrated stock and sector bets – so the poor showing this year should come as no surprise. What may have gotten lost when these funds were selected is that their returns are dominated by growth factor and market risks; their alpha generation often lacks persistency.

The fact that these funds have been piling into private positions may have softened the blow. However, that’s an accounting gimmick. Unless valuations recover quickly, the forces of gravity will eventually require private positions to be marked to reality. At best, in our view this will smooth returns – but make them difficult to compare in the future, as investors need to look carefully at the returns and analyze how different parts of the fund were valued. 

There may be a role for some limited exposure to these funds in portfolios, but any outsized allocation would have caused a huge hole that destroyed diversification from the economic growth risk that dominates most investors’ portfolios. 

The value of the diversification is increasing. As is the value of liquidity. The BoE made the current sentiment amongst policy makers strikingly clear when it said that there are “no ifs and buts” about the priority of bringing inflation down. The market signals “Mission Accomplished”– likely as prematurely as when G.W. Bush put up the banner on the USS Abraham Lincoln. And it’s exactly in this moment when the market positions itself against the Fed and thereby undoes some of its hard work through the easing of financial conditions that it should feel good to have liquid alternatives in the portfolio. But, as we saw in the first half of this year: strategy and manager selections do matter.

Hedge Funds

Hedge fund managers enjoyed positive returns in August, a volatile month in markets as debate continued on the outlook for inflation and economic growth as well as the path of global monetary policy heading into the Jackson Hole Economic Symposium. Quantitative strategies posted strong results across the board, particularly in defensive strategies such as CTAs that came into the month positioned for further USD strength and higher bond yields, whilst fundamental Credit and Event strategies were generally positive.

Discretionary Macro exposures have been more variegated in recent months, as rising growth concerns and the ‘peak inflation’ narrative has reduced managers’ conviction in the monetary policy trajectory and terminal rate pursued by central banks. This led some to cover themes poised to benefit from higher inflation and interest rates, while others had reversed course completely in anticipation of a more dovish hiking cycle than what consensus might suggest. However, with supply shocks continuing to proliferate in Europe, UK inflation reaching double-digits and the release of the July FOMC minutes that confirmed the committee’s resolve to get inflation back to target, more managers have re-established short bond and interest rate positions in August as they brace for an increasingly aggressive response from central banks following Jackson Hole. This has driven strong performance for the space as investors have priced in a more hawkish policy path from the Fed and other central banks throughout the month, whilst in currencies bearish themes playing Europe’s energy dependence and China’s negative carry momentum have also worked well.
 
Quantitative strategies enjoyed a strong month. Trend Followers have positioned themselves around the bearish eurozone narrative that has driven much of August’s positive performance, particularly through shorts in EUR and Euribor futures combined with longs across the European power and gas complex. Systematic Macro strategies traded the bond sell-off well, particularly in short-term interest rates, whilst longs in coffee helped in the closing stages of the month. In terms of micro-focused strategies, equity market-neutral funds that are less aggressive in penalising equity style exposures are flat after recovering in line with value and momentum factors, while machine learning strategies are positive. Quant credit is also up for August. 

August has been a positive for Event driven strategies as the month got off to a strong start with the binary Avast transaction, a widely held position in the arb community, receiving UK CMA approval. Performance continued to build as risk arb markets traded firmer, with tighter spreads, solid new deal activity and financing risks fading. Some deals exposed to China SAMR approval weakened on news of delays and timeline extensions. Special Situations benefited strongly from the bullish markets and managers rotated from single name shorts in favour of portfolio hedges. In Asia, relative value trades continued to perform well, and the convertible bond market saw some improvements. Managers continue to be very cautious with their China exposures, however last week Chinese tech companies got a boost after the US and China signed an initial audit agreement covering US-listed Chinese firms, which may stave off forced relistings. Conversely, this may weaken the outlook of corporate events activity in Hong Kong.

We have seen more muted Equity Long-Short returns this month, as the choppy pattern of manager performance generally shadowed the broader equity markets that have oscillated between negative and positive performance. European-focussed managers have lagged alongside regional indices as investors remain worried about tightening gas supplies and a weak economic outlook. There have been reports of managers taking more risk throughout the month with prime brokers noting increased hedge fund exposure both long and short; European-focused managers were a notable exception. On the long side, funds have added to healthcare, large cap technology, and growth exposure, though exposure to the latter remains well below the elevated levels seen over the past few years. Funds actively added on the short side as well, despite ‘meme stock’ and short squeeze risk remaining at the forefront of investor’s minds following July’s short side woes.

Corporate Credit managers generally posted positive returns during the month as credit dispersion picked up and idiosyncratic stressed and distressed credits performed well. Unlike July, rate hedges contributed positively. Capital structure arbitrage and certain post-reorg. equity positions as well as SPACs were also positive contributors. Financial preferreds held up reasonably well, helped in part by floating rate coupons resetting higher as well as positive idiosyncratic developments. Credit-sensitive convertible bonds also performed well after lagging during the rally in underlying equities in July, whilst a pick-up in new issuance and exchange activity during the month added to gains for some managers. Modest spread tightening, strong carry and gains from rates hedges drove the positive performance for Structured Credit managers.

 
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