Man FRM Early View - September 2021

The message couldn’t be much clearer – tapering is coming. The last six weeks have seen increasingly explicit signposts that the Federal Reserve intends to reduce their government bond purchases from November 2021 through to June 2022, with rate rises following in late 2022 (if Eurodollar traders’ expectations are to be believed). While the precise message may be different, most of the major central banks are following a similar tune. Inflation data remains robust, and patience with extreme levels of negative real rates on government debt across developed markets appears to be running out.

In hindsight, we may view September as an inflection month when markets finally caught up with this narrative and changed direction. The S&P 500 Index was down for the first time since January, and long-end bond yields found little resistance to start to move back to more sensible levels given longer-term inflation pressures. Within the many market threads keeping us entertained as we returned to our desks after the summer was both: (i) the Evergrande saga, where one of China’s largest property developers was over-levered and warned of the risk of default, fuelling uncertainty over the potential outcomes; and (ii) the fun and games in the energy sector, particularly natural gas, leading to parabolic spikes in power pricing across Europe and (at least, at the time of writing) 10 energy suppliers going bust in the UK. The post-pandemic landscape seems to be one of inflation (both push and pull) and a higher cost of financing, neither of which are generally considered conducive to asset price appreciation or corporate performance.

None of this is particularly insightful. The challenge is that no one seems to know what to do about it. We believe investors are sat on handsome levels of paper gains, mainly in equities, after the surging performance of traditional assets over the last year. Lots are clearly trying to hedge through options, as evidenced by put-skew pricing close to the highest levels ever seen, and historically wide discrepancies between realised and implied volatility in S&P and Nasdaq futures for most of September. The popularity of this approach is making it an expensive course of action.

Active hedging strategies aren’t an easy solution either. A few years ago, some of the bright minds in the hedge fund industry started to implement dynamic hedging approaches; essentially overlays that try to detect spikes in volatility early and buy into protection for short windows, thereby avoiding the cost of a static hedging programme. We’ve seen generally poor performance from these strategies over the last year or so. Since sell-offs only tend to last a day or two in the new normal, these ways of identifying spikes in volatility have been poorly calibrated and left buying volatility at the top of a mini-spike when the rest of the equity market is busy ‘buying-the-dip’.

If hedging through static or active approaches is either too expensive or ineffective, then the answer may be diversification. With bonds losing their diversification benefit in a possible inflationary regime, this could then force investors to be more creative. After a sluggish few years of asset growth, the hedge fund industry saw 10% growth in the first six months of 2021 alone¹, and this appears to have only accelerated through the third quarter. We believe the problem here, of course, is that even at USD4 trillion of assets, these liquid alternatives lack sufficient capacity to diversify the enormous pool of equities – taking the MSCI World as a proxy, equity investors have generated USD13 trillion of profits in 2021 alone. The conversations that we have been having with some of the largest institutional allocators in the industry have been ever more strenuous – the need to diversify their equities is matched by the paucity of effective paths to take.

So, there is not always a clean solution to the problem. In fact, one might argue that a financial system in which investors can always diversify away risk and always hold onto gains is not one that functions effectively, particularly when those gains have come as a somewhat unintended consequence of monetary stimulus. It is easily conceivable that as central banks return to a more normal relationship with economies, we could see both equities and bonds fall from their current elevated valuations to ones which more accurately reflect the present value of future cash flows and risks. Giving back just a portion of the spectacular gains made since 2009 by a naïve portfolio of equities and bonds feels like a fair price to pay for a more stable economic system and more central bank ammunition for the next crisis. One can only hope that policymakers can see tapering through without being distracted too much by the wails of investors.

Hedge Funds

Hedge fund performance was more volatile in September than it had been for several months, as underlying markets and strategies also saw higher levels of volatility. In particular, the risk-off episode in the middle of the month, around the Evergrande situation in China, and then again at the end of the month were epicentres of hedge fund volatility. In general, despite the noisier backdrop, many funds finished the month close to flat, with few large outliers. Those strategies that suffered from the pick-up in volatility at the end of the month generally did better in the early part of September and vice versa.

With most major equity markets down over the course of the month, there was a clear negative return to beta, in particular exposure to growth-oriented beta within equity markets which saw a significant pull-back in the final week of the month. One positive outlier within equity markets was energy stocks, which have generally benefited from supply-demand dynamics in the sector. Regionally, Japanese equity markets look to be a positive outlier, with cyclical stocks driving gains. Domestic re-opening sentiment has been boosted following strong vaccination progress and lifting of restrictions.

Equity long-short funds were broadly flat through the first three weeks of the month, generally exhibiting positive alpha in the face of small equity market declines. However, the final week of the month saw more selling of crowded names and led to a deterioration of alpha. Managers were net buyers of the Value factor from the middle of the month, supporting the Growth to Value factor rotation seen at the end of the month. Positioning softened during the month, particularly during the more volatile periods with net and gross exposures both down from the highs seen in the summer. Anecdotal evidence suggests that multi-strategy managers have reduced equity long-short gross exposure more than stand-alone operators.

Credit markets were largely insulated from the two periods of equity market volatility seen during the month, with loans and credits generally flat to small positive through the bulk of the month. The rise in government bond yields seen during the last part of the month was generally negative for overall credit pricing, although credit spreads remain tight. As with equity markets, energy-related names continued to do well on rising commodity prices. On a more granular level, there were positive returns for managers exposed to SPAC trading and convertible bonds, with continued strength in various strategies exposed to forms of capital structure arbitrage.

Relative value strategies have also been somewhat insulated from market dislocations during the month, suggesting that the pick-up in volatility hasn’t caused widespread deleveraging across the hedge fund space. Merger arbitrage returns have been mixed during the month, with spreads remaining volatile but at largely similar levels to the end of August. Areas of continued merger activity include bank consolidations, private equity-led deals, and opportunistic cross-border deals involving companies in the UK and Japan. Volatility arbitrage strategies had a mixed month, with skew levels in many markets becoming extremely elevated as market participants sought to hedge unrealised year-to-date equity gains.

Quantitative strategies in equity market neutral had a good month in aggregate, although there was noise throughout the month as different factors performed well at different times. In general, Quality factors underperformed for much of the month, including during the market sell-off in the last week of the month, whereas blends of Value and Momentum were generally positive throughout the month (albeit with episodes where one would significantly outperform the other). Non-factor led strategies such as technical statistical arbitrage and machine learning generally did well during the month.

Macro strategies had a mixed month, with trend strategies generally seeing small losses from a volatile period. Long equity exposures have been a detractor for much of the CTA universe, with these positions coming down as we progressed through the month of September. Managers are also now starting to build short bond positioning and getting longer commodities. The aggregate of these three changes (shorter equity and bonds, longer commodities) suggests a repositioning in line with higher inflation trends. One bright area in the quant macro space is around quantitative commodity specialists, who generally benefitted from the very high level of volatility in areas such as natural gas.

1. Source: www.hfr.com