# Man FRM Early View - September 2020

## Markets

‘All plausible outcomes are bad’ – that’s a rough summary of the media talking about the US presidential election. The darkest fears amongst the commentariat seem to be reserved for an uncertain outcome, though our sense is that over the last decade or so a great deal of fundamental damage has already been done to confidence. Not just in the political institutions, but in the democratic model itself across large parts of the world.

One small measure of the extent to which we have already arrived at a consensus on the election itself is the volatility market, which shows the implied volatility of options immediately after the election to be lower than those of options expiring weeks and months beyond the election. The implication of this might be that whatever our distrust of the forecasts, volatility markets don’t believe that the equity market will be busy responding to a clean result either way. In other words, we believe the result being that dreaded thing: ‘indeterminate’. Counterintuitively, one could argue that political despair implies market stasis.

This post-election options pricing is all the more striking given the recent demand / supply imbalance in the volatility markets and the elevated price of, say, the VIX Index in recent weeks. Unsurprisingly, retail behaviour seems to have been altered materially by lock-down: buying options, rather than selling them, seems to be a much closer substitute for a good night out at the pub. (The market bought around $30bn of calls on the top five tech stocks in August 2019. It bought$130bn in August this year: that’s some night out.)

Furthermore, institutions have been reticent sellers. Perhaps the sharp movement at the beginning of February 2018 is still discouraging the shorts, but more significantly one wonders if we are looking at a response to the bleak landscape of current asset pricing. Bonds no longer offer the same dependability as diversifiers of risk assets (US bonds may have one good crisis left in them, but Northern European holders got no help from their bonds in March, while the Italians were reminded that the theory about government bonds as risk free assets isn’t very good). Gold seems to be correlated to equities, and as yields rise, it’s been historically correlated to bonds too. So, with diversification to equities so thin on the ground, selling volatility is not high on the average CIO’s list of priorities.

This line of argument – that a shift in the supply and demand for options might explain a change in the price level – doesn’t feel very controversial. Of course, somehow one has to surmount the challenge of the accounting identity which plagues all flow related arguments: there have to be an equal number of buyers and sellers, or the buyer can’t actually buy from anyone. Sometimes this attack reveals that in the interests of ‘clarity’ the analyst has forgotten to count the other side of the equation, but we think that in this case, the notion that the volatility level had to adjust higher to clear the market does seem fair.

Risk premia more generally seem to be structurally dependent on this style of argument, but with equity factors it quickly becomes subtle, dizzyingly complicated (always a bad sign) and sometimes painfully wrong. The glib summary one hears occasionally is that there is no return left in trading equity factors because too much money is chasing them. Superficially this is fine: if everyone wants to buy the cheap stocks and sell the expensive ones, then Value spreads will never be wide enough to cover costs and we’ll get bad performance. QED.

If only. Our current problem is that the ‘cheap’ ones seem so very persistently cheap. We bought them ages ago at higher prices and now there aren’t enough buyers to make them go back up. On closer inspection, even the hypothesis is a bit ticklish: buyers need to be just frightened enough by something risky in the stock to let it go cheap, but only for long enough to give us a chance to buy it, after which they need to remember that the risk should confer an excess return and pile in…not ignoring that accounting identity.

There are a few other sideshows round this baroque dance. We can argue these days about what ‘cheap’ really means – whoever it was that thought of the term ‘intangible assets’ clearly had a sense of humour that’s been wasted on us intellectual proletarians. Then there’s the zero (and negative) rates problem, which properly messes up the Discounted Cash Flow models as a basis for valuation. The list could be a long one, but we definitely shouldn’t forget Covid-19, which has driven a snowplough through earnings forecasts. In the face of even just these three big and very agile drivers of Value, perhaps the flow argument is just a bit too subtle for now? And that sort of worry very quickly starts to drive all the other factors too…starting with Momentum.

People who liked the idea of factor returns in recent years and allocated capital to the space (thereby helping it along) are now changing their minds in face of all this and don’t want to play anymore. This makes for a big negative flow: they need to sell the (cheap) stocks they bought (higher up), and that goes to make them cheaper. Our dancing partner is treading on our toes.

You don’t have to believe that factor trading is dead to see that with all this going on you might get high correlation between supposedly orthogonal factors and erratic performance for a time.

This is all a rather elaborate way of saying that trading the same things as everyone else is apt to get you into trouble; herd immunity is as desirable and evasive in markets as in epidemiology; equity factors are a relatively weak driver which is apt to disappear for a while when big new things start happening; Covid-19 is a very big thing indeed and it doesn’t seem to be going away; and though most of us would like democracy to function better than worse through early November, that’s the one concern we think the market seems reasonably untroubled by. Strange world.

## Hedge Funds

September was a very mixed month for hedge fund performance, with asset markets exhibiting higher levels of volatility and a reversal in many macroeconomic trends, led by renewed risk-off positioning in equities and FX given growing concerns over a Covid-19 second wave. In general, Credit strategies held up better than Equity Long-Short, and most Relative Value strategies outperformed Macro, although factor-driven Equity Market Neutral continues to struggle.

Credit market behaviour was generally conducive for hedge fund performance, at least on a relative basis, as within High Yield the lower-rated parts of the market held up reasonably well, as did the Loans market. US High Yield Long-only funds saw meaningful outflows towards the end of September, which affected pricing, but this seems to have been most pronounced in the ‘BB’ end of the High Yield spectrum. As a result, Credit hedge funds held up reasonably well in terms of performance, with many managers reporting either small positive or flat returns for the month. The best performing strategies seem to have been Convertible Arbitrage (again, following stellar returns through the summer) and stressed/distressed Credits. Managers feel there is still considerable opportunity in the Credit space, with the focus shifting from the more liquid parts of the universe towards distressed and restructuring situations.

Structured Credit managers also performed notably in September, with a continuous decline in the loans in forbearance and only a slow uptick in delinquencies across most sectors. While there has been a pickup in new issuance in certain sectors post-Labour Day in the US, demand remains robust.

Equity markets were a harder place for hedge funds to benefit in September. Headline indices were generally down on the month despite a brief rally in the last few days of the month. Factor volatility increased, as markets saw a rotation out of Growth into Value during the first part of the month, only for this to reverse in the latter part of September. Manager data suggests that not many firms did well in this environment; the longer biased strategies suffered losses to beta, the tech specialists suffered from an even bigger pull-back in the Nasdaq, whereas Value strategies also underperformed over the whole month (despite starting well), as intra-sector Value/Growth dynamics widened further in the second half of September.

Quantitative strategies in equities fared a little better. Factor models suffered a similar fate to their discretionary peers, with Value starting the month well before fading whereas Momentum struggled to begin with but eventually recovered.

Faster strategies focused on Liquidity Provision generally held-up well, benefitting from elevated (but not extreme) levels of market volatility, whereas Machine Learning strategies produced mixed returns depending on their factor positioning coming into the month.

Trend following managers had a particularly difficult month in September, with large losses in the second half of the month on a renewed ‘risk-off’ appetite across most asset classes. The main sources of pain were short USD positions in FX, particularly relative to the GBP and AUD, which reversed sharply on concerns over Brexit and global commodity demand respectively. This hurt long positions in Commodities, particularly precious metals such as Silver and Gold, as well as Natural Gas. Losses were exacerbated by the general long equity positioning of most managers, which snapped back in the first few days of the month, whereas long bond exposure was generally a positive driver of returns, although positioning here was lighter than usual given the last few months of largely sideways pricing in fixed income.

Event Arbitrage had a volatile month. Merger Arbitrage and Asian Relative Value situations performed positively, but US holding company structures (‘holdco’) have seen discounts widen, mostly driven by flows. M&A deal activity remained robust in September, with new deals trading at tight spreads, and with a lot more pre-announced and hostile situations as well. Activity in Europe has now also increased, although mostly in the smaller/mid-size category. We believe there are some new situations where majority investors appear to be taking advantage of nominally low valuations and launching bids to take out minority shareholders.

Some notable developments in widely held M&A deals are the adjustment to the terms between two European car manufactures, which removed some uncertainty from the merger. As well as the attempt of a luxury brand to back out of their offer for a luxury jewellery firm, which likely will now go to court in January 2021. The flow of new SPAC IPOs is continuing to attract a lot of capital, with only a modest indication of increased focus on valuations.