Man FRM Early View - October 2020

Hedge funds were dealt a sharp blow in the last week of October, despite generally positive returns in the first half of the month.

Markets

Markets have spent much of 2020 trying to force the Covid situation into a controlled narrative. Lockdowns were bad for the economy but were necessary to protect healthcare systems and to save lives. The negative economic impact could be offset by monetary stimulus and (barring the odd hotel chain or cinema provider going bust) most companies could be supported by cheaper debt and targeted government support. As virus cases fell to lower, more stable levels, it was easy to believe the situation was under control (at least in the developed markets). We’d manage the situation with acceptable restrictions to our way of life, and through a combination of better treatment, better testing, better management of risks and better tolerance of necessary evils, we’d slowly get back to normal while we waited for the silver bullet of a vaccine. After the initial panic, the Equity markets could continue on their merry way as if nothing had happened.

If only it were that easy. The recent rise in number of cases and deaths from Covid in Europe has seriously disrupted our sense of control. As hospitals begin to reach capacity in the worst hit areas, the uncomfortable reality that we might not have any choice about new lockdowns has swept across the continent. Equity market investors in Europe must now face the realities of genuine and prolonged impairment to growth, which now looks set to spread from the already depleted industries of Retail and Travel to the supposedly more-insulated parts of the economy. It is no surprise that the earnings miss by one of Germany’s largest tech companies coincided with the big leap higher in the VIX Index on 26 October. Two days later we had national lockdowns announced in France and Germany. How quickly the unpalatable has become the necessary.

At the time of writing we don’t know the outcome of the US election – but how much does an increase in Democratic representation at the national and state level also increase the possibility of more lockdowns there, coupled with bigger fiscal stimulus? Getting the market implications of that balance right is horribly uncertain, and the second wave of Covid is only magnifying the problem. Take one example – the Value-Growth spread.

Generally, fiscal stimulus leads to a steeper yield curve which leads to a higher discount rate, so a narrower spread, right? More political will to lockdown the economy leads to a repeat of the stay-at-home tech outperformance of old economy cyclicals, so a wider spread, right? Do tax rises for the rich inhibit speculative Equity market retail investors who help to prop up those tech valuations? Does fiscal stimulus put more money in the pockets of low to middle income families, some of which is used to buy a new iPhone?

Is it any surprise that even before the spike at the end of October the VIX was still frequently flirting with a level of 30. The ‘fear index’ has become the uncertainty index. Mapping a course through the possible shape of a second wave, and the response of policy makers to it, seems impossible, especially when the identity of those policy makers isn’t known yet. Maybe, after some thrashing around and a bit more stimulus to oil the system, investors manage through this wave of further lockdowns to the sunlit uplands of 2021 (or, maybe, 2022) when cases are again on the wane and perhaps we have a working vaccine and the apparatus to deliver it to sufficient numbers of people, allowing societies to return to normality. So, the actual direction of Equity markets from here is as opaque as ever, and sentiment around whether we are moving forward or moving backwards in tackling the virus is likely to be more important than the absolute magnitude of the problem. But the structural level of volatility in the system is linked to uncertainty and a clear outcome to the US presidential election could help to at least clear the ambiguity, as would positive news on phase III vaccine trials and a semblance of a roadmap to widespread delivery.

It was always going to be hard for individuals, politicians, investors, and society-at-large to agree between the competing demands on healthcare and the economy, especially when for some this is literally a matter of life or death. In our view the old playbook of monetary support and yield curve control has worked well, up to a point. However, as the grim implications of the pandemic extend, we are witnessing a shift of the ultimate backstop from central banks to governments, from monetary to fiscal, from institutions where decision making is made easier and faster by the simpler mandates and simpler organisational structure. Fiscal policy is altogether less flexible and much harder to implement. As the stock of debt piles up, inflation would appear to be the only way out. But standing here, that once again seems a little further over the horizon.

Hedge Funds

Hedge Fund performance was dealt a sharp blow in the last week of the month with the sharp sell-off in Equity markets, the associated rise in volatility, and signs that some de-risking was taking place across a number of active strategies (albeit not at panicked levels – at least at the time of writing). It is interesting that the focus of most discretionary hedge funds has shifted a number of times in the last few weeks; from concerns over potential chaos around the US election if the result is undecided on November 4th, then to a relief risk-on move in reaction to the strong polling of Democrats that suggests more clarity from the election (regardless of long-term policy implications), to the current increased fears on the implications of surging Covid cases in Europe and the announcement of new lockdowns.

Overall performance for the hedge fund industry in October appears to be broadly flat to negative, with generally positive returns in the first half of the month offset by losses through to month end. There was a high degree of dispersion of returns in most strategies, and therefore generalisations over which strategies did well or poorly for the month are harder than usual to discern. In our view, some Relative Value strategies appear to have done well particularly Event and Merger Arbitrage, although even here spreads started to widen in reaction the volatility in the last few days of the month.

For Equity managers, beta was a negative contributor by month end, with most indices finishing in negative territory. Factor exposures were extremely mixed, with higher than usual volatility in traditional factors such as Value and Momentum. In general, Value strategies did better during the first part of the month, but saw some giveback in the last few days, but this phenomenon is quite noisy by region, sector and by market cap. Overall risk exposures were high through the early part of October, with both gross and net exposure above long term averages based on Prime Brokerage data. There seems to have been a significant unwind of this positioning into the last week of the month though as volatility increased and markets sold-off.

In Credit, it was generally a positive month, although volatility in the last week reduced several managers’ performance back towards flat. For most of the month US Treasuries were weaker and the curve was steeper on hopes of a new stimulus package. US High Yield spreads tightened against this backdrop, and for most of the month High Yield outperformed loans and Investment Grade Credit. There were renewed inflows into US High Yield funds after outflows in September, while the US preferred markets saw some new deals after these were largely absent for the past few months.

Convertible Arbitrage was generally a beneficiary of the sustained higher volatility environment, while SPACs saw modest weakness driven by continued heavy new issuance.

For Structured Credit, the US housing data continued to show strength in October as forbearance trends remained favourable. Spreads across most securitised credit sectors were tighter during the month until the last few days of volatility.

Merger Arbitrage strategies generally had a positive month, as several large deals closed over the last few weeks, generating excess capital for redeployment. Spreads tightened overall through most of the month, although some situations were caught up in the volatility towards month end. M&A activity has continued to increase during October, mostly in the US, but notably in Japan. As noted above, those Arbitrage strategies focusing on SPACs saw some weakness in October after a run of very positive months through the summer.

Systematic Macro strategies such as CTAs saw a mixed month in October, with largely positive performance in the first part of the month (recovering September losses), but a more difficult environment in the final week. Long Equities, particularly US Equities, helped in the first part of the month and the degree of give-back during the last week was largely driven by the speed of the managers’ signals. Similarly, the general short USD exposure was positive in the early part of the month but was one of the core areas of losses during the more volatile period at the end of the month. Commodity exposures were mixed, with positive returns from long exposure to metals and agriculturals helping in the first half of the month but then turning to losses, whereas the short exposure to energies was generally a positive contributor throughout the month.