Man FRM Early View - February 2021

A strong month for hedge funds despite the risk-off end to February.

Markets

What should one make of the market noise at the end of February? It's a curious conflict between rather good fundamentals and rather shaky technical dynamics. The real-world data on vaccine efficacy from Israel and the UK seems to confirm pharmaceutical trials and further supports the idea that as vaccine programmes are rolled-out globally, then the economic impact from Covid-19 should start to decline. The fourth-quarter corporate reporting cycle was generally strong and struck a note of optimism, in many sectors of the economy, for a return to normal behaviour and a release of pent-up consumer demand. Here in the UK, we now have a 'roadmap' to getting back to normal, and (particularly for parents home-schooling their children while trying to do their day-job) the relief is palpable.

But with a fundamental normalisation comes a degree of technical rationalisation, particularly in the bond market. The US 10-year yield took six months to get from around 0.5% at the end of July 2020 to around 1.0% at the end of January 2021, and then hurdled the next half a percent rise in February alone. Other country's curves, particularly those more exposed to commodity price inflation such as Australia, have made even greater leaps over the last four weeks.

There has been, of course, no shortage of market commentators pointing out that the stimulus necessary to keep economies functioning during the pandemic might be an issue for monetary stability once the crisis was over. The success of vaccine roll-outs and falling infection rates globally appears to have been a tipping point for something of a binary shift in expectations – one might now better comprehend circumstances that lead to rate rises in a way that was incomprehensible a few months ago. In his speech on 24 February, Federal Reserve Chair Jerome Powell continued to toe the party line, but markets carried on pricing higher yields anyway. There is little chance of central bankers acting too soon this time around – markets are more fearful of them losing control of the curve and being forced to raise rates earlier than the economy would appreciate.

But – and here's a hostage to fortune when we write the next letter in the ruins of a market crash – so far there feels relatively little to be overly concerned about. Yes, there has been the gnashing of teeth over spikes in volatility across most asset classes, and individual share prices have been trading over large daily ranges while they search for a new equilibrium. However, when one cuts through the noise there is little here that should surprise us. Long-term real yields on government debt shouldn't be quite as negative as they have been for much of the last year (one might make the argument that they should be positive when the pandemic is no longer the dominant economic issue, which means that yield curves need to steepen a lot more than they have already, even under modest inflation expectations). Positioning in equities, and particularly growth stocks, was clearly a bit frothy over the last few months, and more sensible risk-sizing of exposures is a much-needed check on over-exuberance. And did anyone really believe that the Fed was never going to raise rates again? Current expectations of a US rate rise in late 2022 hardly feels reckless, particularly since higher inflation expectations have emerged in lockstep with improving economic fundamentals.

Perhaps we are a little complacent given the positive returns to hedge funds so far in 2021, as active investment strategies appear to be navigating the turbulence of the late-Covid markets particularly well. We have long harboured concerns that some strategies, particularly Macro strategies such as CTAs, are bond-proxies and would struggle to react to a world of rising rates. These concerns were less based on data than the lack of data since bond yields have been falling for the last 30 years. And while it is a short window, the positive performance of these strategies over the last six months (and particularly in February when yields were rising at their most precipitous) has been reassuring. The broader picture remains positive across other strategies too. The factor rotation from Growth to Value has been navigated better than similar episodes in 2020. We are often all-too-quick to point out when hedge fund returns have disappointed at times over the last 10 years, it seems only fair to acknowledge their success. In a world where the risk premia associated with traditional assets such as equities and bonds might be facing a period of repricing, it is reassuring that, so far, alternative assets can continue to generate returns and diversify.

Hedge Funds

Hedge funds enjoyed a very strong month in February across many strategies. Performance in equity and credit strategies recovered strongly during the first half of the month as the deleveraging pressures seen in the last week of January continued to ease. Managers had generally booked enough positive P&L early in the month to withstand the risk-off move seen during the last week of February. Other strategies were also positive, with notably strong returns from both relative value and macro managers.

In equity long-short, the alpha landscape was particularly good for the first three weeks of the month. Managers benefitted from a return to short alpha in the early part of the month as the short squeezes from late January largely subsided. In addition, February was a busy month for fourth-quarter corporate earnings, which helped to accelerate the alpha generation in 'reopening' themes. The final week of the month saw a sizeable risk-off move with equities lower and a material rotation out of technology stocks and into cyclicals, leading to an outperformance of the Value factor over Growth. While there were some losses from beta exposures and the factor rotation in the last few days of the month, most managers finished with positive returns.

In credit, high yield spreads narrowed in the face of rising bond yields during most of the month, although the risk off move at month-end saw the absolute value of high yield start to decline. By mid-month, high yield (and in particular CCC) spreads were close to the lowest levels since the global financial crisis. The same is also true for the US high yield distress ratio – preliminary data suggests it was another month of no defaults for US high yield debt.

After an exceptionally strong January, there was some let down in the pace of primary issuance in February, although it was another decent month across corporate credit managers with positive performance across many credit strategies. SPACs had another good month (despite a pull-back in the last two trading sessions), where new issue activity remains strong and there is a continued pace of deal announcements. Convertible bond arbitrage benefitted from tighter spreads and elevated single-name equity volatility, as well as continued high levels of primary issuance. In capital structure arbitrage, managers benefited from the reversal in stocks that were subject to the short squeeze in January, as they are typically long credit versus short equity. Structured credit also had a positive month due to flat or tighter spreads across most sectors.

In relative value, it was another positive month for event and merger arbitrage, despite complications around some higher profile deals that led to significant price action.

There was some noise around the risk-off positioning in markets during the final week of the month, but generally, merger spreads are wide, and there remains good optionality for merger price increases due to buyers bumping premiums (or hostile bids). Managers continue to focus on anti-trust hurdles, both in the US where the Biden administration is expected to take a tougher stance particularly on deals in large cap tech, and in the UK where Brexit is an additional factor in cross-border deals with European companies. The most active sectors for merger activity continue to be pharmaceuticals, healthcare, and technology. Managers continue to note that annualised spreads remain attractive in the space due to the large volume of deals and relative lack of speculative capital invested in merger arbitrage. They also expect private equity acquisitions to grow steadily during 2021.

Statistical arbitrage managers generally had a positive month in February, with returns supported by a recovery from the deleveraging pressures seen in the last week of January. Fundamental managers largely navigated the factor rotation from Growth to Value better than the rotations seen in June, September and November of 2020, and managers with more of a Value bias were again able to post stronger returns than those seen in other recent strong Value months.

For macro managers, there were very strong returns to CTA strategies. Historically, there has been some doubt as to whether CTAs can generate returns in bond selloffs, but February proved extremely profitable for a number of managers. The bulk of the returns came from trends in FX (generally short US dollar positioning) and commodities (long energies), while long equity positioning also helped during the first three weeks of the month. Given the increase in volatility across all asset classes, CTA managers ended the month with much lower risk exposures, and many have now turned either flat or bearish on government bonds. Discretionary macro managers also performed well in aggregate, although success was largely dependent on the directional call on bond markets, and whether managers positioned for a reversion in bond yield too early during the month.