Man FRM Early View - March 2021

What a preposterous quarter that was. Imagine telling someone, on New Years' Day, of all the things that were about to happen. That a violent mob would storm the US Capitol building to try to prevent the peaceful transition of presidential power. That a bunch of retail traders on social media would destroy a large hedge fund by squeezing its shorts to stratospheric valuations. That this would lead to the worst deleveraging event for equity hedge funds in over a decade. That another huge family office would blow up due to its own over-levered portfolio, leaving investment banks with multi-billion-dollar holes in the balance sheet (and, no doubt, a few stern questions being asked of the risk management desks). That inflation fears would accelerate, adding 40bps to US 10-year breakeven inflation (finishing the quarter at its highest level since 2013) and 80bps to US 10-year bond yields. That Value stocks would outperform Growth stocks by the biggest quarterly margin in years, leaving many of last years' stock market champions well below their peaks. That seasoned investment professionals would know to whom you were referring by the names 'Qanon Shaman', 'Roaring Kitty' and 'Technoking'. And that, despite all of this, the S&P 500 index would finish the quarter at another record high…

Woe betide anyone trying to predict what happens next. In the bigger picture, this is a calibration issue. After the deepest and sharpest recession in living memory, we now face the other side of the chasm as fundamental data threatens to be unprecedentedly good over the next few months. Maybe we see 10% US nominal GDP growth for 2021. Maybe US CPI tops 4% at some point in Q2. Some story around inflation seems to be the prevailing narrative for most market commentators, but few can agree on what that really means. The more feverish fantasies see a world where central banks lose control of yield curves and/or run out of ammunition to deal with the next contraction of financial conditions. While these may be true, western economies have spent much of the last 13 years finding ever-deeper ammunition supplies for their policy makers. The Bank of Japan has managed to maintain yield curve control throughout this crisis (a central bank who, by necessity, have always been two steps ahead of every other developed economy in how to run low rates and a high debt/GDP ratio essentially forever).

For now, the Fed claims to be able to see through the noise, and they have made it very clear that not only is there no need for tapering, there's no need to talk about tapering. At the last Fed meeting, it seemed there was no need to talk about talking about tapering. Such a resolute response makes it even harder to bet against them.

And it's possible that the Fed has this right, and we enjoy a few quarters of super-normal growth as the Covid impacts fall out of the data and then markets and economies settle back into the patterns seen in the second half of the 2010s. Yield curves could steepen a bit more and we see US 10-year rates back in the 2-3% range. Yes, we have a few trillion dollars more on the central bank balance sheets, but this can be dealt with over the next few decades by letting inflation creep a few basis points higher than previously targeted. Equities feel expensive again, but since when did relative valuations really affect the level of equity markets. Bonds become a diversifier again, offering real protection in risk-off periods. Eventually, when things have calmed sufficiently, the Fed can taper its asset purchases and (even further down the line) start to raise rates again. Maybe.

In the short term, however, risks abound. Market participants are still relatively risk-on; from hedge funds still running close to record levels of gross exposure, to retail investors who once again have propelled the price of Gamestop back to around USD200/share; from CFOs issuing record levels of convertible and corporate bonds, to CEOs announcing continued mega-mergers (despite, one assumes, Covid preventing much face-to-face due diligence taking place).

Being a risk manager in this environment is unenviable. Not only is the volatility landscape elevated, it is particularly unpredictable. Traditional techniques for managing risk are less effective now – how should a hedge fund manage their short book when even large-cap stocks can double (or more) in the space of a month? Factor volatility is close to record highs, but factor models seem to be at their most ineffective given the changing correlation landscape inside equity markets (i.e. for much of the last three years Value and Momentum have been negatively correlated, now that appears to have flipped to positive). Who would bet against another rollercoaster ride of market events in the second quarter, or that, somehow, the S&P 500 finishes the next three months at another record high?

Hedge Funds

Hedge funds experienced a mixed month in March, with variable performance both within and between different strategies and styles. Risk assets generally continued to rally through the month, leading to gains for managers with equity or credit market beta, but the alpha landscape was relatively poor. Even within strategies that typically exhibit higher intra-sector correlation, such as Managed Futures or Event Arbitrage, there were considerable differences in manager returns.

In general, Equity Long-Short managers struggled in March, as they were hampered by factor rotations and struggled to take risk during the month. Most managers failed to capture the market rally in the first part of March having reduced risk in the last week of February. Prime brokerage data also suggests that the most crowded long positions performed negatively despite the overall market rise, particularly in the US. Value has continued to outperform Growth, and the continued dovish sentiment from the Fed led to small caps and cyclicals underperforming.

Despite the rally in equities it was a slightly more muted month for credit markets. Investment Grade remains weak, driven by the continued move higher in rates, whereas lower-rated high yield outperformed due to the more equity-like characteristics of the market's cohort. Primary market issuance of credit remains extremely strong; March was the second highest new-issue activity month for the US high yield market, mainly driven by refinancing activity. Against this backdrop, credit manager performance was mixed.

After a recent strong run, SPAC trading saw a change in market sentiment which impacted post-deal names and left many IPOs trading below trust value. Similarly, convertible bond arbitrage saw some modest cheapening in convertible bonds this month, with very heavy issuance in the early part of the month and a small drop in volatility. Returns from structured credit managers were slightly positive, but again it was a more muted month than the recent history. Most of the performance was attributable to carry, with mixed performance across sub-sectors in terms of spread moves, with legacy RMBS among the best performers.

Event arbitrage managers were generally positive performers during the month, albeit with a spread of returns around zero. M&A deal activity remains high, especially in North America and China, with a continued focus on Financials, Industrials and Tech companies. In March there were six new deals announced over USD10 billion in size, as mega-cap deals continue to dominate the landscape – and the pace of deals is even more remarkable given the inability of many of these companies to meet face-to-face (given the continued Covid restrictions).

In general, merger spreads have widened slightly during March, with continued concerns that proposed US anti-trust appointees will exhibit a political tilt to situations around healthcare and tech names.

Quantitative equity market neutral strategies generally performed well in March, with returns increasing particularly during the second half of the month. The factor landscape continues to be noisy, with correlation structures changing as Value is beginning to correlate more with Momentum as the recovery trades in markets become extended. Factor strategies that focus on Value or blends of Value and Momentum therefore performed particularly well in March and continued their good YTD returns. Mean reversion strategies also performed well in March, with managers befitting from choppy markets that generally failed to extend their moves upwards or downwards. Machine learning strategies appear to have also performed well in March.

Trend following managers experienced a volatile month in March, and after a positive start it now appears that March was a losing month for the majority of managers. Commodities trading was generally negative, since elevated volatility in the energy commodities led to lower exposures there and managers generally lost money from metals trading, particularly long exposure to copper. Equity exposures led to mixed performance where, despite some markets such as the US reaching new highs, other markets were sideways and choppy. Similarly, managers now have relatively light exposure to fixed income, and have begun to flip exposure from long to short given the prolonged negative performance of government bonds. In FX, the US dollar strengthened late in March which generally hurt managers.