Man FRM Early View - May 2020

May was a mixed month for hedge fund performance, with positive returns from risk-on exposure in credit and equities offset by generally negative returns from systematic strategies, particularly in Managed Futures.

Markets

Suppose I offered you either a guaranteed $94k, or a 95% chance of winning $100k (with a 5% chance of getting $0), then I suspect you’d take the guaranteed amount despite the probabilistically weighted outcomes of the latter being better. However, if I said you could either pay me $94k, or take a wager that has a 95% chance of losing $100k and a 5% chance of not losing anything, most people would take the wager, despite again being the probabilistically wrong choice. This concept of Prospect Theory (i.e. that investors’ value functions are different for losses than for gains) won Daniel Kahneman the Nobel Prize for Economics in 2002.

His work feels particularly pertinent today as we sit in the midst of one of the deepest recessions in economic history, and in a unique position relative to previous recessions – that the simple yield return on most government bonds from here is (as near as makes no difference) zero. The only way to make anything like the returns of the last 10, 20, 30 years from government bonds is if developed market central banks embrace negative rates with gusto. And in doing so, they probably need investors to be as willing to accept a loss for security of capital as they were to accept a gain, relative to other assets. As Kahneman suggests, the shape of the function of investors’ appetites changes as the expected return passes through zero. It’s little wonder that central banks seem so reticent to cross that particular Rubicon (despite teetering so close to its bank for much of the last decade).

If we don’t see progressively more negative rates over the next few years, then the case for bonds as a diversifier to equities looks flimsy from where we are today. It is a lot easier to swallow short-term negative correlation if both assets make money over the long-term – otherwise one side of your portfolio is just holding back the other. And if all that stimulus eventually does find its way into inflation, that situation is arguably worse – we wouldn’t need negative rates anymore, but who wants to be sat on two assets with low expected real returns that lose money at the same time?

But while the expected returns from passive portfolios of traditional assets appear to be declining, one might reasonably believe that the active management of assets is due a long-awaited day in the sun. As hedge fund investors, we are of course somewhat biased here, but emergence from a recession is arguably the best point of the economic cycle for active strategies to differentiate between corporate winners and losers.

The particular challenge in this recession is to untangle the identity of those winners and losers in the face of so much persistent uncertainty around the fundamental drivers of the recession (the virus, the policy response, the behavioural response, political incompetence etc). What is clear is that the ‘knowable’ themes have been dominant thus far and it feels like they’ve largely played-out. The outperformance of ‘stay-at-home’ winners versus losers has led equity markets to have one of their thinnest market rallies on record over the last two months (as measured by outperformance of a capital-weighted index vs an equally weighted index).

And you can’t pretend to be an active investor just by buying the best quality companies in each sector (a.k.a. the factor bet). Most active managers are either trying to beat a benchmark if they are long only, or trying to generate an outperformance of their long book versus their short book if they are a hedge fund. The problem with just buying ‘quality’ is that if the fundamental picture improves quickly (let’s say there is a breakthrough on a vaccine tomorrow), then it is often the junk that outperforms. And besides, in equity markets the Quality factor is by most measures very expensive relative to history right now.

So investors need to be truly idiosyncratic and, as with any period of economic stress, there appear to be opportunities throughout the capital structure. Whether high yield credit as a whole is cheap or expensive at these levels is hard to call without a better read on the solvency of the corporate sector 6-12 months from now (which as we’ve said seems largely unknowable in today’s rather unique circumstances), but it does feel like there are more degrees of freedom in the corporate debt universe to differentiate between winners and losers. Relative Value trades within the capital structure of the same company (Equity vs Debt or Convertible Bond Arbitrage), particularly in stressed and distressed situations, feels like a fertile area for finding trades that generate profits regardless of the economic fundamentals. The opportunity gets even better in strategies like Distressed Debt, where the investor is able to influence the outcome, or w here hedge funds are able to pick-up bargains from other distressed sellers, such as in the Structured Credit universe.

Even just within the equity market it feels like a good time to be a stock picker. The managers that we speak to think they can find high quality companies with strong balance sheets that are expected to both survive the current economic difficulties (and thereby take market share from weaker peers if things get worse), but that are also well-placed to benefit if the economic backdrop improves.

It is, of course, hard to be overly confident in any forecasts, but there is a palpable sense of excitement for the opportunity set that we hear from discretionary equity and credit managers that we haven’t heard for a long time. If we do enter a better period of generating idiosyncratic returns (dare we be as brave as to call it ‘alpha’?), then when they are executed well they can be uncorrelated to other assets. Positive returns which diversify our investors’ core equity holdings? That sounds a lot like what we used to get from government bonds.

Hedge Funds

May was a mixed month for hedge fund performance, with positive returns from risk-on exposure in credit and equities offset by generally negative returns from systematic strategies, particularly in Managed Futures. Within equity markets, the rally continued to be led by a small portion of the market, and factor volatility remains elevated despite the reduction in headline market volatility.

In equities, we are starting to see managers increasing gross exposure gradually to capitalise on opportunities, particularly within Financials and other beat-up areas of the market. From a discretionary angle, we are seeing managers increasingly picking through ‘value’ stocks given the extreme undervaluation of this part of the market, although despite a recovery in Value names in the final week of the month, Growth continued to outperform Value for the month as a whole.

Event Driven strategies in equities were more mixed. While the month started well with a smooth completion of the large and widely held acquisition of Allergan by AbbVie, post-Covid idiosyncratic risks were demonstrated by volatility around the MSCI index rebalancing mid-month and especially the unilateral withdrawal of the PE firm, Advent International, from its acquisition of ForeScout technologies, which subsequently initiated litigation for violation of deal terms.

More generally, merger spreads continued to tighten early May, even approaching pre-crisis levels, but this trend broke mid-month and various risk concerns and the roll-off of several larger deals led to some moderate widening of average levels. Deal activity continues to be drastically lower than early 2020 and especially late 2019, and is unlikely to pick up materially before late Q3.

Quantitative Equity Strategies were broadly flat in May, with a continued high level of dispersion between manager returns. As noted about, the increase in volatility in factors has made managers reticent to deploy too much exposure, and in particular the losses to Value strategies continue to weigh on returns despite the recovery in the final week of the month. Signals built around Free Cash Flow metrics continue to perform well, but other Quality factors have softened following their very strong performance during the worst of the sell-off in March.

In Credit, there was a continued rally – driven by expectations of an improvement in recovery prospects as global economies continue to open up after the shutdowns over the past 2+ months; also potential breakthrough on the vaccine front; and continued strong fiscal and monetary support globally. High Yield securities outperformed Investment Grade, and caught up some of the ground lost from the Fed intervention in the Investment Grade universe in April. Energy credits were clear winners supported by the recovery in Oil prices (but they continue to lag significantly on a YTD basis.

Corporate credit managers generally posted positive returns in the month; the magnitude though was much less than April. Managers saw gains in outright stressed/distressed credits, capital structure arbitrage in the Energy sector, and GSE preferreds were positive on news of the hiring of advisors to be out of conservatorship. There were also gains in select Convertible Bond Arbitrage positions; but the overall CB market was somewhat stable as supply has prevented the market from rallying further. Financial preferred securities were flat to modestly up, albeit with some areas of softness after a strong few weeks.

There were also positive returns for Structured Credit in May as markets continued to heal. In RMBS, there were reports that more borrowers in forbearance are staying current vs. historical levels; also some slowdown in new forbearance requests – potentially driven by increased amount/duration of unemployment benefits as well as borrowers receiving paychecks from PPP loans. Agency credit risk transfer bonds saw continued spread tightening in the month as did legacy RMBS (though less so than CRT bonds). ABS spreads also continued to narrow in the month – strong demand in primary and secondary markets and limited supply; as did CLOs. Spreads also tightened across parts of the CMBS sector, but lagging other sectors on a MTD/YTD basis.

From a macro perspective, Managed Futures managers generally lost money in reversals across most asset classes, in particular the net short positioning in Oil (which has helped so much YTD), led to the worse of the losses. Other asset classes were mixed, with slightly positive returns from FX despite a recovery in commodity-linked currencies such as the CAD or the AUD. Discretionary Macro managers continue to produce mixed performance, with fewer opportunities in rates given the normalisation of government bond vol.