Editor’s Letter – Issue 148

April | May 2020

Hamlin Lovell
Originally published in the April | May 2020 issue

In unprecedented market conditions, wide dispersion between managers within strategies and sub-strategies creates exceptions to any generalization, and could prompt a rethink of risk models. Directional strategies have generally done better than relative value approaches, partly due to liquidity issues. The fact that bid offer spreads blew out to 10 times their normal level could have a massive impact on some convertible arbitrage managers or a leveraged emerging market strategy that prices longs at the bid and shorts at the offer. But there are relative value traders – such as an agricultural arbitrageur we will profile in the next issue – who have had their best ever month in March 2020. 

Within the directional quant space, faster models have mostly outperformed slower models, which is perhaps unsurprising given the Covid-19 crash was many times faster than even the climax of the 2008 crash. CTAs trading on technical price data have, on average, outperformed systematic macro funds using fundamental data; yet a few systematic macro funds have really shined.

This time around, Covid-19 has been described as “the mother of all black swans” for MBS.

Hamlin Lovell, Contributing Editor

Volatility trading is more nuanced than long managers profiting and short managers losing. Short-biased volatility strategies have not necessarily lost money: if their risk management was tight enough to cap losses during the panic, they will have been able to sell volatility at very high levels, and profit from market normalization.

In credit, asset backed securities, including mortgage-backed securities, and structured credit, have historically sometimes proved relatively resilient during credit market routs that have hurt corporate credit. This time around, Covid-19 has been described as “the mother of all black swans” for MBS. Commercial mortgages, threatened by shopping shifting to e-commerce, are now in some cases deeply distressed. Some strategies invested in junior or mezzanine tranches of corporate credit CLOs have also seen record losses. Yet a handful of nimble traders have made positive returns.

In other strategies, Covid-19 has exaggerated and amplified multi-year trends in factor behaviour. The outperformance of growth and quality factors, and technology and healthcare sectors, has been extended, and correspondingly, so too has the outperformance of US versus European equities. Meanwhile, the value style of investing has underperformed by an even larger margin as the “cheap” sectors, including banks and energy, have been hardest hit by the crisis. This has led to another leg down in quant strategies emphasizing the value style, but it is possible to find quant equity market neutral funds up on the year.

Adaptive risk systems can help. For instance, historically, long oil company exposure would have been counterbalanced by owning airlines, which profit from lower oil prices, but in March 2020 the correlation has inverted as both sectors have plunged. Factor risk management models based only on history need to be reviewed and may need to be radically revamped to adapt to the current climate.