Man FRM Early View - June 2019

Hedge funds enjoyed a positive June across most strategies.

  • Government bond yields continue to fall despite the rally in equities
  • Hedge funds enjoyed a positive June across most strategies
  • Equity Long-Short returns were largely driven by market beta given the scale of the market bounce

Markets

All sorts of new problems emerge when you exceed the speed of sound: it’s called a barrier for a reason. But in time those issues with over-heating, engine thrust and aerodynamic drag in the transonic region have all been overcome to a point. The financial engineering problems thrown up as bond yields go through zero are perhaps no different. It’s true that Karl Marx’s work on the key role of capital in the evolution of human society does somewhat skip over the question. Perhaps he thought negative yields a trivial detail for some student to tidy up much as da Vinci did the sound barrier in his early work on planes.

But to those of us of limited ability it is a blessed relief that there aren’t too many quizzical Martians wandering around asking for an explanation as to why history is so dominated by the need to control something which you then have to pay someone else to borrow. In the middle of the month, Euribor broke the floor that has supported it since the beginning of 2017. Everywhere yields have been heading to the far south. The more we think about it, the worse it seems to get both now and in future; both in magnitude and absurdity.

Hedge funds, however, will have none of it. When Swiss rates first approached zero, some trend followers scaled their Euroswiss futures positions towards zero in the belief that zero yield would be a floor. It wasn’t, and the fix was removed, a decision fully vindicated they would say by subsequent results. Yes, the directional systematic funds checked that the code still works when you plug in negative yields and interest rate futures priced above 100. Beyond that there is very little to discuss…a point they are apt to make with some animus. There is no reason why an instrument with a negative yield cannot have positive carry (if the funding rate is even more negative) and there is no reason why it cannot continue to have positive momentum as the yield falls further. Some even say (more animus) that there is no yield at which that argument breaks down – a view at which to raise one or two eyebrows, in theory at least. The whole point about trading momentum is that you just don’t know what trend comes next, and if it were possible to know less than this, then it is in situations like this you would know it.

Volatility traders have had to make a few technical changes to the way they estimate distributions as yields approach zero, but they did that years ago. Traders who scale their market exposure up when volatility falls have had to think carefully about how far they want to go as, measured some ways, the volatility of zero yielding bonds can get very low. If volatility goes to zero, an infinitely large position feels like too much. But again, this is neither a new problem, nor a new way to experience an old problem as Japan has been showing us the way for decades.

For many in the systematic market neutral equity world, the problem of negative yields is also small beer. No one has talked of re-engineering the models for negative yields: and some confess, almost sheepishly, that actually rates don’t get into the models at all. Most trade long short within a sector so as long as one bank experiences the negative rates the same way as the others, they can still buy the cheap one and sell the expensive one. Provided they stay sector neutral, they have no exposure to the fact that banks may hate negative yields more than pharmaceuticals.

For the managers who trade traditional factors, the inquiry goes a little further. Growth stocks, we are told, underperform value stocks over the long term. But when rates fall, the discount rate applied to the earnings falls too. Since for growth stocks these earnings are way out in the future, this may lead to powerful outperformance. The data which shows that value doesn’t like very low rates may be more suggestive than compelling, but the intuition behind the argument is strong. So, if you are a value trader, don’t you need to say at what level of long term rates the belief in value fades? One possible answer is that it is the change in rates that drives the outperformance of growth rather than the level, so these problems are transitionary rather than steady state. They hope.

At successively lower levels of yields investors switch from bonds to equities as they trawl for income. This may lead some lower volatility equities to outperform. The flows are large so this often shows up also as cross-sectional momentum and like other good things, you can have too much of it. Managers cap this exposure because momentum changes its name to crowding when it’s overdone. While the point here is to suggest that lower rates can weasel their way back into the process by any number of back doors, arguments of this kind apply to changes in yields in different ways at different levels: it’s not unique to the zero yield threshold.

In short, then, as far as hedge funds are concerned, our analogy to the sound barrier is hopeless: zero is a number barely different to any other in the yield world. Whatever they’re trading, whether momentum, value, uncertain views or over-certain views, hedge funds mostly don’t care much about negative rates. Perhaps this is good: hedge funds are meant to take risks which do not typically permeate the core portfolio.

Is it more like the time variable in key physics equations? You can reverse the sign without anything much going wrong (and that’s certainly just as baffling.) The catch is that you can’t reverse entropy so you can’t reverse time in that context: you can’t unscramble eggs*. But we suspect the parallel works here too. Since unscrambling the vast mountains of debt that are so rapidly accumulating at these levels will be no easier than turning those eggs back to their natural state, we’d best make sure that hedge fund processes are similarly independent in both directions of change.

* It should be clear by now that this author knows nothing about aerodynamics or theoretical physics.

 

Hedge Funds

Hedge funds enjoyed a positive June after the more difficult market environment in May. Rising equity and bond prices were positive for most strategies, with long exposure in research driven strategies across equities and credit benefiting from a return to risk-asset beta, whereas macro strategies are generally positioned with longer bond risk that they have held for some time, on an expectation of looser central bank policy globally.

In Equities, the biggest driver of returns was market beta given the scale of the market bounce, particularly in the US. Growth continued to outperform Value, but managers are also seeing bond-proxy stocks performing positively as bond yields fall further. Managers are generally sceptical about the extent to which loose monetary policy can support markets this late in the cycle, and have therefore not been pushing their net long exposure too much into the market rally. However, most think that we could see some kind of trade resolution through the second half of the year ahead of the US election year in 2020.

Quantitative Equity strategies also had a noteworthy month in June, with positive returns from factor exposures after a challenging period over the last twelve months. Short term trading strategies performed positively, as did strategies with longer term futures exposure (since these strategies tend to overlap with the Managed Futures strategy).

There were a number of large deals announced in the Event space during May and June, which has led to wider spreads across the space given the size and early-stage nature of many of these bids. Managers have commented that the opportunity set from the space has therefore improved, with more breadth of opportunity than they have had for much of 2019 so far.

The continuation of the rally in government bonds was behind a noteworthy month for Macro managers, with particularly positive performance from the Managed Futures strategy. Most managers remain long equities despite the pull back in May. The biggest negative contributor for Systematic Strategies was FX as the dollar pulled back on the month. With the volatility seen in Gold and Oil during the month, Macro managers experienced mixed performance from commodity exposure during the month. The more discretionary managers remain bullish on China around expectations of a thawing of trade war tension following the G20 meeting.

The risk-on month led to notable performance for Credit across the board with both HY and IG markets performing positively, the latter driven by the continued rally in treasuries. Higher quality US HY credits also outperformed in June as a result (of the lower yields). Floating rate leveraged loans, with a lower forward Libor curve, were the clear underperformer in the month as the markets price in a more aggressive (in cutting rates) US Fed. Outflows also continued from the leveraged loan asset class while US HY funds saw inflows in June.

A strong market backdrop coupled with positive idiosyncratic developments in several large situations resulted in most corporate credit managers posting positive returns in the month. Not surprisingly, managers with significant single-name short books and/or meaningful index hedges underperformed in June. Bonds and equity of a bankrupt utility, on positive fundamental news, were positive performers in the month after a sell-off in May. Corporate credit managers also benefitted from a restructuring deal between the Puerto Rico oversight board and commonwealth bondholders. A takeout of a large US reorg gaming company benefitted distressed managers. The discount for a holding company stub position narrowed on a favorable tax ruling, benefitting credit managers with an RV allocation as well as event managers. GSE preferreds gave up some of the recent gains as the US Treasury Secretary cast doubts on a quick recap and release plan.

Spreads across most securitized products sectors were also tighter in June tracking corporates. The higher beta credit risk transfer sector outperformed. Any Fed rate cuts could be supportive of mortgage fundamentals in the near term, potentially benefitting the residential sector more broadly. Structured Credit managers though largely up in the month underperformed corporate credit managers in June.