Man FRM Early View - January 2021

A month of two parts for the hedge fund industry.

A disparate band of protagonists, enabled by new technologies and social media, fed by conspiracies and half-truths, acting in concert to achieve their collective goal, playing the part of modern Davids giving the establishment Goliaths a bloody nose. There are similarities between the angry mob storming the US Capitol building in the first week of January and the angry mob storming the stock market in the last.

For both bands of players, it's hard to see what their sound and fury achieves in the short term. Many of the Capitol raiders have now lost their jobs and are facing criminal charges. Many of the small investors from r/WallStreetBets have been buying equity in near bankrupt firms at as much as 30x the value of a month ago. Once the music stops, there will be no justification for the extreme valuations of these stocks. As with every bubble, many of the holders of the companies will have lost nearly everything they invested.

It is easy to overstate the role of these retail assets in the enormous market deleveraging seen by hedge funds in the last week of the month. Yes, the losses to a few players on short positions in those specific companies may have been the first domino to fall, but the rest of the chain was overextended in positioning led by the post-vaccine exuberance of the last two months. Much of the deleveraging was driven by portfolio managers seeing an increase in systemic risk and reacting accordingly. One might point to the broader economic concerns of: i) limitations to vaccine supply; ii) new variant strains of coronavirus; and iii) a realistic downgrading of President Joe Biden's ability to pass large fiscal stimulus, as equal catalysts for increased nervousness in the broader hedge fund community.

But we should not understate the longer-term implications now that the retail genie is out of the bottle. Who will be to blame for the losses incurred by these investors? In an open society, and within the rule of law, people are free to invest their own wealth however they see fit. But when things go wrong, individuals often find it hard to blame their own stupidity and begin to look elsewhere. Already ire has turned to the regulators and to the stock-trading platforms that have restricted purchases of the most volatile stocks, as they were seen to be protecting the established market participants (rather than the reality of protecting themselves and new investors).

It seems to us that the appetite for such forays into volatile stock trading will lose their appeal once enough members of the community have been burned, and that heavy-handed regulation is maybe more damaging to the integrity of markets than allowing nature to take its course. But the increasing democratisation of stock trading through technology and the role of social media in co-ordinating investors actions feels like a phenomenon that is here to stay. It seems likely that hedge funds could be more reticent in the future to take short positions in small capitalisation or crowded stocks, and that retail flows become a more important factor in understanding market volatility than previously considered. Maybe, after a decade or so of investors switching from active management to passive index trackers and ETFs, this represents a new dawn of active investors – one that we're sure the established market players would welcome with open arms over the longer term (regardless of the recent flesh wounds).

All of which feels like an apt preamble to what could be another volatile year. Investors must again digest huge swings in economic growth and corporate earnings in 2021 as things normalise post-Covid, and the magnitude of the changes is itself a driver of noise. After all, what constitutes large earnings 'beats' or 'misses' when expectations are already supersized? Investors must be wary of getting ahead of themselves and discounting only the sunlit uplands of the post-Covid landscape when the situation remains in flux. It seems increasingly reasonable to assume that by 2022, at least, there will be a return to something like normality for global economies post-Covid, but the vagaries of the effects of excessive monetary and fiscal stimulus on asset pricing are both important and hard to fathom. If the last year (and the last week in particular) has taught us anything, it is that the long-term fundamentals of a situation are so often subordinate to the short-term sentiment, technical pressures and unexpected events.

Hedge Funds

January was a month of two parts for the hedge fund industry. The first three weeks were a continuation of the previous month and a half, with strong returns across a number of strategies driven by continued risk-on positioning in markets, beneficial for trend following, credit and equity long-short, and high levels of capital market activity and primary issuance, serving as a tailwind for a number of relative value strategies. The final week of the month saw a sharp reversal in all these trends; markets turned risk-off during sharp deleveraging from active market participants and relative value strategies suffered losses from existing positions.

Equity long-short strategies had the most varied month for some time. The deleveraging volumes in the final week of the month have been described by several prime brokers as the most severe since 2008. US firms appear to have been hurt more than other regions, due to the social media attacks on well shorted names in the US market, and the higher level of crowding on both the long and the short side of many managers' portfolios. Anecdotal data suggests that some of the larger US equity long-short managers suffered significant losses during the last few days of the month. In Europe and Asia, the situation was more muted, with some contagion felt through Monday 25 January to Wednesday 27 January, before alleviating in the final two trading sessions of the month. In Japan, Value strategies enjoyed another good month (following a positive December), with the continued decline in performance from Momentum factors throughout January.

Credit seems to have weathered the deleveraging storm with relatively little bother. Loans were the best performing sub-strategy during the month, and there were some outflows from high yield funds which accelerated into the end of month risk-off move. Despite the outflows from the space, lower-rated credits outperformed for much of the month. Credit arbitrage strategies also performed well, with positive returns from convertible arbitrage. Structured credit was also positive during the month with tighter secondary spreads and flatter credit curves across most sectors.

Relative value strategies have enjoyed a very strong run of performance in recent months and this continued through most of January. SPAC exposures continued to generate strong returns, but these saw a material correction in the final week of the month given the deleveraging activity at large multi-strategy hedge funds. However, most managers are still reporting positive contributions from their SPAC exposures for the month despite the noise at month-end, and there continues to be a record level of issuance of SPAC structures. The January 2021 SPAC issuance has already exceeded the entire year of issuance for every year except 2020.

In Merger arbitrage, managers are continuing to see more competitive pressure pricing acquisition targets higher, even for deals agreed some time ago, as shareholders want to capture more upside and buyers are willing to spend more in order not to lose the transaction. As equity markets pulled-back into the last few days of the month there was some contagion into average merger spreads, although at this stage the impact has been modest and largely technical. New deal activity has remained robust through January.

Statistical arbitrage strategies struggled with the factor dispersion and deleveraging towards month end. Managers were largely positive through the first part of the month, but than saw some losses in the early part of the last week. Faster strategies, particularly those in machine learning styles suffered the worst losses on the deleveraging days, but then saw the biggest rebounds to performance as the pressure reduced on the last two days of the month. Longer term factor strategies generally held up well through the start of the deleveraging period but then lost money in the final few trading sessions on weaker performance of the momentum factor. As to be expected, the larger, more levered equity market neutral strategies suffered the worst losses in the deleveraging, and as with the equity long-short strategy, those with the largest exposure to the US (and in particular, the smaller-cap cohort of US stocks) suffered the largest losses.

Trend following managers also has a turbulent month, with generally strong performance through the start of the month (on long equity and short dollar positioning), which was cancelled out during the final three trading sessions on the sharp risk-off reversal. Many managers finished the month close to flat after being up materially in the middle of the month. Following a number of months with FX exposure (short dollar) dominating the risk profile of many Trend following managers, we are now seeing these exposures starting to flatten on a prolonged period of FX volatility.