Man FRM Early View - November 2020

Hedge Funds generally enjoyed positive returns in November thanks to falling volatility and rising risk assets.

Markets

One suspects most of us will be glad to see the back of 2020. But in Hedge Fund land it has been a year of near-consistent disappointment for quantitative Equity Hedge Funds, with losses at the start of the year, losses in the market sell-off, losses through the summer and (to compound matters) losses in November.

It wasn’t supposed to be this way. Since the GFC, conviction levels in, and capital allocations to, quantitative Hedge Funds have increased enormously relative to discretionary managers. The machines seemed to cross a critical level of power or sophistication, and suddenly they seemed to be eating all the low-hanging fruit. What happened?

Two of the most persistent philosophies of quantitative Equity analysis are those of Value – buy cheap and sell expensive – and Momentum – what worked well yesterday will continue to work well today. While other factors exist, particularly in the academic literature (and thence in quantitative funds seeking to replicate the academic literature), it is Value and Momentum that are the most tractable to the layman.

2020 has been a blow to the head for those of us who try to explain markets using these labels. A third factor – Covid– seems to have left all other considerations subordinate. Labels such as Value and Momentum suddenly become hostage to nuances in the calculations; if the price of, say, an airline stock falls 80% then whether you’re using last year’s actual earnings or next year’s forecast earnings matters a lot in determining whether the stock is ‘cheap’ under the Value metric. Similarly, once a stock has fallen so much, the label of ‘short’ Momentum starts to lose meaning too, since a continuation of the absolute size of declines in market capitalisation would quickly push the share price through zero. And let’s suppose you iron out these computational wrinkles, your Equity risk model then must work out whether these stocks now represent long ‘Value’ or short ‘Momentum’, or do you allow them to be both? Trying to force stock behaviour into one box or another can be a good idea in normal times, as it lets models identify distinct baskets of stocks out of a large universe that best explain each factor.

But this falls down when the majority of stocks are being driven by a new influence, as this narrows the breadth of the Equity market drivers and makes it harder to find stocks which are uniquely Value or Momentum (or anything else for that matter).

Which brings us to recent events. The Pfizer vaccine announcement on 9 November 2020 saw a snap-back in the single stock behaviour of the previous eight months. Since, by definition, it is impossible to calibrate Equity risk models particularly well to explain market moves by such nascent influences as Covid, we once again fell back on the labels of Value and Momentum. “Value had a good day”, whereas “Momentum had its worst day ever” (by a factor of about 2x based on most industry measures). Perhaps a better way to describe it was that the Covid factor went sharply into reverse, and the more familiar (but wholly inadequate) labels convulsed wildly in its wake.

This idea of factor labels becoming redundant when there are individual shorter-term market phenomena that dominate stock pricing is not new. We saw this in the dot-com bubble and in the GFC. Analysis of traditional factors in these periods shows that they start to show increased co-dependence - in the case of Value and Momentum, to exhibit negative correlation. Intuitively this makes sense; something else is causing a cohort of the market to fall and another cohort to rise. As this ‘something else’ persists then the first cohort exhibits increasingly long Value characteristics and increasingly short Momentum characteristics; the second cohort exhibits the opposite. Once these become entrenched then it becomes inevitable, since even an alleviation of the ‘something else’ sees stocks all move back towards their previous existence, leading to continued co-dependence between factors, at least for some time.

This is important when we think of the recent returns to factor driven strategies. Most quantitative blends of traditional factors have really struggled with this dominance of the Covid factor this year. Poor performance in the first ten months of the year was explained by losses to Value factors overwhelming smaller gains to Momentum factors, whereas in November, losses from the Momentum factor overwhelmed the gains from the Value factor. This feels like a mischaracterisation of what’s really been going on. It seems that trying to compel new market forces to submit to the old models of market behaviour has led to chaos for quantitative Equity market Hedge Funds – no more so than in November, where on the vaccine announcement days the Covid factor was the only game in town. Just as in 2000-01 and 2008-09, the inflection point is still one of high co-dependence between traditional factors, since to get back from such extreme market dislocations sees the disparate cohorts of ‘winners’ and ‘losers’ still exhibit correlated behaviour as they all start to move back towards some kind of normal.

But history suggests that as the normalisation period develops, then this factor co-dependence breaks down and stock behaviours go back to being explained by a variety of fundamental drivers. This also makes intuitive sense – there comes a point at which beat-up stocks may have recovered enough to no longer exhibit negative Momentum, but haven’t fully recovered to their former glory, and hence still represent some form of positive Value. With the benefit of hindsight, it was perhaps over-simplistic to pin the recent travails of the quantitative Equity Hedge Funds on the underperformance of the Value factor, at least for 2020. What they perhaps need is for the Covid factor to lose its dominance, and then they can once more benefit from the academic factors to explain stock returns in more normal times. The vaccine news is therefore less about what happened to stocks on individual days in November, and more about the increased confidence in a roadmap back to normality for quantitative Hedge Fund performance.

If nothing else, it’s clear that 2020 represents an Achilles’ heel in the Hedge Fund machines, namely a real failure to grapple with unique new drivers of stock returns that don’t fit the academic models. Even the newer ‘Machine Learning’ approaches felt somewhat impotent, since you need to learn from something, and probably rack up losses while you’re learning. It seems to us that, even if it is only to point the machines in the right direction, we may still need humans in this game for some time yet.

Hedge Funds

Hedge Funds generally enjoyed positive returns in November thanks to falling volatility and rising risk assets. Markets were buoyed by the results of the US election showing a likely split between Republicans controlling the Senate and Democrats controlling the Presidency and the House of Representatives. Continued support came from positive Covid vaccine news from Pfizer, Moderna and AstraZeneca. Across Hedge Fund strategies, quantitative Equity Market-Neutral and growth biased Equity Long-Short strategies struggled, but many other strategies saw positive returns.

Equity Long-Short mangers generally benefited from the rally in Equity markets, which was enough to offset any factor losses from Momentum positioning. Unsurprisingly, the best performing managers were those with net long exposure to beat-up sectors such as Banks, Consumer, Resources and Energy. European exposure generally did better than US exposure, which again is symptomatic of the reversal of the market behaviour from the first ten months of the year.

In Credit it was an exceptionally strong month across the board, as High Yield outperformed Leveraged Loans and Investment Grade, with outperformance led by the sectors most directly affected by the Covid lockdowns, such as Transportation, Energy, and Leisure. Retail investors supported the risk-on move, with strong inflows into High Yield Bond mutual funds.

For Credit Hedge Funds, it was a positive month across the board with all sub-strategies ending in the black. Convertible Arbitrage managers benefitted from the strong market backdrop, and traditional Credit strategies benefited from tighter spreads across all Credit products. More specifically, Government Sponsored Enterprises preferreds had a good month on reports that the regulator might be seeking an exit from conservatorship before the change in administration.

It was a similar story in Structured Credit. Spreads were again tighter across most sectors and fundamental data has continued to improve, with a strong ongoing recovery in housing as well as improving underlying consumer data trends such as, the continued decline in forbearance levels and increased mortgage payments. The only Credit strategies to underperform appears to have been the Systematic Credit strategies – which have suffered from a quality bias towards Investment Grade over High Yield.

Equity Market-Neutral strategies generally struggled in November due to the extent of the factor rotation caused by the positive vaccine news, which saw Momentum significantly underperform. Many traditional Equity Long-Short funds saw losses from the Momentum factor offset by positive Equity market performance, whereas Equity Market-Neutral funds did not have this beta exposure to offset the losses. Prime Brokers reported material de-grossing across Europe and Asia driven by covering of short positions in Momentum/Growth names. Faster and more technical quantitative strategies in Equities appear to have not been affected by the factor rotation, with many managers reporting positive returns for the month and muted performance on the days of the vaccine announcements.

Relative Value strategies appear to have done well in November. Merger Arbitrage had a strong month across all regions, with busy deal activity across all regions and in all types of deals. Merger spreads tightened materially on the risk-on sentiment around the vaccine news, and several large deals closed during the month. Looking towards next year, managers generally expect the M&A landscape to focus on strategic additions by market leaders rather than mega-deals. SPAC investments continue to be popular, with a high number of new deals coming to market during November. SPAC trading was once again generally positive for Hedge Fund managers in November after the pull-back in October. Other Relative Value trades also were generally positive contributors to performance, with a range of ShortVolatility strategies significantly benefitting from the steep fall in implied volatility.

Managed Futures strategies also appear to have finished November with positive returns, despite the anti-Momentum sentiment around the vaccine announcements. Managers have been broadly long Equities in recent months, which has helped to offset the general negative Momentum moves in other asset classes. In particular, Bond exposure was a detractor to performance in the first half of November, as yield curves steepened on expectations of a quicker return to normal economic activity. Managers profited from the rally in Commodities, including the strong recovery in Oil prices.