Man FRM Viewpoint - December 2018

The return of elevated volatility to global equity markets marked the worst December return for the S&P 500 Index since 1931.

  • The HFRX Global Hedge Fund Index fell -1.93% in December, bringing its YTD return to -6.72%.
  • The return of elevated volatility to global equity markets marked the worst December return for the S&P 500 Index since 1931.
  • Emerging market performance over the month also suffered, but was broadly more insulated than its developed market counterpart.
  • Yield curve movements and geopolitical events continue to drive the global macro outlook.


Hedge funds have clearly not covered themselves in glory during 2018, experiencing their worst year since 2008 and disappointing investors for the second time in three years following a poor 2016. However, the behaviour in December gives us more hope. In the face of significant equity market declines, large parts of the industry held up, with declines in hedge fund indices being driven by long exposure to equities and high yield credit rather than alpha. As we noted last month, the industry appears to have deleveraged significantly in October and November, leading to losses from Market Neutral strategies, but we didn’t see further waves of deleveraging in mid to late December as the worst of the market sell-off took hold. In fact, returns to Valuation metrics turned positive and remained subdued during the worst of the volatility at the index level, leading to better returns from Quantitative Equity managers than we have seen for a while.

Equity Long-Short managers had generally reduced both net and gross exposure aggressively in October and November, and as such were generally able to trade the volatility seen through December. As might be expected, longer biased managers struggled to overcome the headwind of significant equity market declines during the month, but lower net and market neutral managers performed better. Asian markets continued to be among the more difficult regions to trade, whereas European alpha seemed to be higher than in other regions. Managers with a Value bias also tended to outperform, although risk factor returns were noisy over different regions and time-periods.

December was another challenging month for the corporate credit markets on continued geopolitical uncertainty, declines in equities and crude oil, and heavy outflows from US high yield and loan funds. US high yield spreads widened to levels last seen two plus years ago with lower-rated credits (CCCs) on average trading at distressed levels. Leveraged loans were also hard hit with expectations of a slower pace of US rate hikes in 2019 leading to heavy retail outflows from the floating rate asset class. A noteworthy rally in treasuries helped the investment grade markets post a positive month. All US high yield sectors were negative in December. Energy and Retail were the worst performers while the defensive Utility sector outperformed other sectors. Primary markets were pretty much shut in the month given the volatility and the meaningful weakness in both loans and bonds.

Corporate Credit managers mostly posted negative returns in December as there were very few if any places to hide given the market backdrop. As one may expect, Credit Long-Short managers with single-name and market hedges outperformed the longer-biased Distressed managers with the latter most impacted by the equity exposure. US financial preferreds were once again particularly hard hit. Most securitised product sectors also saw spread widening in the month. Longer spread duration assets including lower-rated tranches of CLOs and credit risk transfer deals underperformed while spreads for legacy assets held up comparatively. December returns for Structured Credit managers were on either side of the flat line with carry offsetting most of the losses from mark-to-market.

December was a positive month for CTAs, concluding a generally negative year for the strategy as a whole. December was interesting due to the dispersion between manager positioning and performance across asset classes. Nonetheless, in aggregate by asset class, Commodity and Fixed Income trading was generally positive, while Equity and FX were detractors.

In commodities, crude oil and products was the largest driver of gains, with managers almost all positioned short. Natural gas was the largest detractor, suffering a large reversal following the noteworthy rally in November. Most managers generated positive returns in Fixed Income, due to long positions across a range of geographies – US treasuries were the one detractor, with short positions working against managers. Equities were close to flat in a month that had large moves in headline indices. Short positions in Europe were positive and generally offset losses from small long positions in the US.

FX was also close to flat. Managers remain short FX against the USD (JPY is the only major currency that managers are long). Statistical Arbitrage managers had some respite in December following a negative run of performance through October and November, and in aggregate the strategy was close to flat.

Fundamental strategies generally benefitted from a notable month across regions for both Price momentum and quality based factors (though value continued to do poorly). As there always seems to be during poor periods, there were rumors of risk reduction going on in the space in October and November, with the theory that this was impacting the technical reversion players. Whether true or not, this clearly wasn’t the case in December, with many technical managers positive.

Other Relative Value strategies also saw positive performance, particularly in the light of the size of equity market drawdowns which can sometimes lead to material widening of risk spreads. The best performing strategy was Volatility Arbitrage, particularly those strategies with a long volatility profile.


Summary of performance drivers by strategy

Key: + Positive factors and/or drivers <> Neutral factors and/or drivers - Negative factors and/or drivers
  Alternative risk premia Trade examples1 Environmental factors

Relative Value (RV)

 - The HFRI Event Driven Index was down -1.93% in Decemeber and -1.73% for the 2018 calendar year …  + Key approvals received for a pending global Pharma merger were notable contributors to positive performance for the month …  - Managers have rotated exposure to US merger opportunities as activity in Europe has slowed in recent months …
 + Merger Arbitrage continued to perform positively during the month as high-conviction pending transactions closed during the month.  <> Managers expect bouts of volatility to provide potential opportunities to enter in spreads at more attractive levels in upcoming months.  + Risk has scaled back as mergers have closed and exited portfolios.

Equity Long-Short (ELS)

 <> Equity Long-Short hedge fund returns were negative, but mainly due to losses from net exposure to falling markets …  - Markets were additionally spooked by a further deterioration in the US China relations …  - Equity markets sold off heavily into the end of the year, breaking the historical precedent …
 <> Volatility levels remained elevated through November and markets began to price in the higher risk premium in the thin markets through year end.  + Many managers have commented that they believe there is an opportunity to add alpha from attractive Relative Value trades.  + European equity indices outperformed US indices in the December sell-off.


 - Fund flows were negative in December with -$7.2bn coming out of US HY bond funds while leveraged loan funds saw the largest ever monthly outflow of -$9.9bn …  + Broad credit market spreads have seen a sharp reversal in recent weeks after trading close to post-crisis tights …  - Structured Credit risks persists due to higher rates and economic surprises …
 + Positive performance contributors werer largely small and idiosyncratic RV names  - US financial preferreds, European financials, energy-related credits and equities, and gaming equities were poor performers.  + Default activity increased only modestly MoM with only two companies defaulting on $2bn in bonds and loans.

Global Macro

 + Macro managers are focusing on a more data-dependent Fed policy and the implications to US growth given the subsiding benefits from tax reform …  - Negative sentiment was fueled by concerns regarding the speed of Fed rate hiking, coupled with further political tumult in Washington …  - The return of elevated volatility to global equity markets, with notable pain in the US, marked the worst December return for the S&P 500 Index since 1931…
 <> The spread dropping to negative levels for the 2s5s and 3s5s curves marks the yield curve’s first inversion in more than a decade.  + Emerging market performance over the month also suffered, but was broadly more insulated than its developed market counterpart.  <> Risk-off behaviour underscored mounting Brexit uncertainty on the back of Teresa May’s securement of her leadership role.

The above summary is based on FRM’s opinions on performance drivers across the hedge fund industry and is not representative of the investments made by FRM. 1. The herein mentioned examples are intended as illustrations of typical investment consideration and/or strategy implementation. It should not be construed as indicative of potential performance of the fund or strategy or any investment made by the fund. It does not constitute a recommendation or investment advice or solicitation to buy or sell any particular securities and should not be considered as any investment advice or research of any kind. There can be no guarantees that similar opportunities will be available in the future or that any opportunities identified will provide similar results.