March 2020 will surely be remembered as a major turning point for financial markets in the modern era. Following on from our previous update, this research note looks in detail at the performance of several core liquid alternative strategies through March 2020 and Q1, now that month-end NAVs are available.
Across the liquid alternative universe, outright positive monthly returns were few and far between during March, although there were several notable bright spots among certain strategies and specific managers. A “win” in March generally constituted limiting losses to low single digits or better – still extremely valuable to portfolios, of course, in diluting the losses in long-only risk assets.
For many strategies, the second half of March was particularly challenging: widespread de-risking resulted in further downward price pressure, exacerbated by heightened illiquidity and extremely wide bid/ask spreads. This was particularly evident in fixed income and currency markets, where spreads in usually highly liquid instruments widened by many multiples. In this respect, March was as much a liquidity crisis as it was a response to the economic impact (actual and presumed) of Covid-19.
Unlike 2008, which played out over the course of months, drawdowns in March 2020 were measured in days and weeks.
March was a month of record-setting. It brought the fastest bear market in history: unlike 2008, which played out over the course of months, drawdowns in the month were measured in days and weeks. Equity market volatility, as measured by the VIX index, reached unprecedented levels of 85.5. Realised volatility topped 100% for the first time since 2008, probably exacerbated by concurrent quarter-end expirations of options and futures on stocks and indices as well as challenging liquidity conditions. Global equity markets fell 13.5% in March, despite a material comeback in the final week of the month: US equities saw the largest downwards move since Black Monday and the worst quarter in over 100 years, while European equity market falls were among the sharpest ever recorded. Oil production tensions led to steep declines in prices, including a 30% drop in a single day. We have also seen unprecedented responses from governments and central banks globally, slashing rates and launching a raft of support measures and stimulus packages to help battle the economic impact.
While implicitly long-volatility strategies such as CTAs and Systematic Macro have sometimes been challenging to hold in recent years, they can deliver material convex diversification in times of market stress. Pure trend-following was one of the standout strategies in March. The HFRI Macro Systematic Diversified index posted gains of +2.9% for the month, while the SG Trend index was up over 1.8%. Long-bond exposures were particularly helpful as treasury yield curves tightened, as were modest net-short positions in equities with many CTA managers scaling back long-equity exposures through February and March.
Yet the sheer speed of equity market declines in mid-March made it difficult for all but the fastest trend followers to respond. As such, short-term and more dynamic medium-term trend models typically outperformed longer-term trend models. Likewise, more diversified CTAs (those implementing other strategies alongside pure trend) fared less well than their pure trend-following counterparts; ‘non-trend’ strategies such as mean-reversion were broadly detrimental to performance. Such differences contributed to the very considerable dispersion in CTA manager returns, which ranged from 10% losses to 10% gains for the month, with higher volatility managers occupying the extremes. For a typical institutional-grade pure trend strategy operating at around 10% p.a. volatility, returns sat around the (positive) mid-single digits for March, whereas the returns for an equivalent Diversified CTA were flat-to-slightly negative (-2%).
Systematic Macro strategies saw March returns broadly in line with those of the Diversified CTAs: the average return across a cohort of institutional-quality Systematic Macro managers operating at around the 10% p.a. volatility level for March was -3%, ranging from around -10% to +7%. Again, managers that incorporated trend-following components to their strategy typically fared better than those without. What distinguishes a Systematic Macro strategy from a Diversified CTA strategy is the significant presence of a non-price, fundamental data-driven models, but it appears that non-price strategies behaved in line with their price-based counterparts in March. Stronger performers seem to have exploited the sharp downward moves in oil through short energy positions going into March.
The second half of March proved particularly painful for the Event Driven cohort. The broader HFRI Event Driven index was down -12.4% for the month, while the Merger Arbitrage sub-strategy index – historically less volatile, with less exposure to equity risk – posted losses of -8.9% over the same period.
Event Driven strategies were hit not just by directional exposures (predominantly to equities), but also by widening spreads as a result of wholesale de-risking. The full force of this indiscriminate spread-widening was particularly visible around March 20th in the Merger Arbitrage space: spreads in some M&A deals went from less than 200bps to 2500bps within a few days. Many managers in this space experienced intra-month losses of close to or more than 10%, before recovering partially towards month-end. Managers proved keen to hold their positions, treating dislocations as attractive entry points. Investors should note that NAVs may include a significant component of mark-to-market, unrealised, spread-based losses which should recover if market conditions normalise and/or deals complete.
Looking forward there are likely to be opportunities to deploy capital into stressed/distressed restructuring opportunities as businesses continue to face headwinds from the current environment. Within the M&A space we would expect strategically important deals to continue and anticipate potentially higher activity from private market capital seeking opportunistic deals.
13.5%
Global equity markets fell 13.5% in March
The majority of the Equity L/S space is directionally exposed to equity markets, with a historic beta of around 0.4. As such it should come as no surprise that the HFRI Equity Hedge index posted losses of -9.5% in March. Yet we note a huge degree of dispersion in monthly returns, with losses of 20% at one end of the spectrum and 20% gains at the other.
Meanwhile, the Equity Market Neutral sub-strategy index lost -2.3% with several managers noting that the velocity of market moves made it difficult to preserve truly market-neutral portfolios. This space was also harmed by its bias towards quantitative strategies (it being easier to maintain a specific profile systematically than via a discretionary process): Quant Equity strategies largely struggled in the second and third weeks of March, with some market participants claiming that virtually every quant factor lost money in that period. Equity Value saw its already unprecedented multi-year drawdown extended in March.
When assessing the wider Equity L/S space, it is instructive to look at the GS VIP index of 50 stocks that “matter most” to hedge funds as a yardstick for performance. For March, the GS VIP index was down over 16% while the corresponding VIP Short book index would have only generated gains of just over 9% for the month, leaving an archetypal L/S manager down 7%. Yet these VIP stocks are often synonymous with ‘crowded’ positions and several managers expressly attributed losses to extreme selling in crowded trades. We note that typically more volatile sub-strategies (e.g. small cap) generally fared worse.
Looking forward, elevated volatility and significant dispersion should provide ample opportunities for Equity L/S strategies, especially ‘double alpha’ strategies that seek to add value from both the long and short books.
Manager performance dispersion becomes even more dramatic as we look towards Global Macro, inherently one of the more nebulous and non-defined hedge fund strategies. While the HFRI Macro index gained 1% in March, some well-known fixed income macro funds posted their best ever returns while other Global Macro managers reported losing more than half of their portfolio value. Outside of the extremes, “strong” performers typically saw high single-digit gains, while the weaker group lost more than 10%, often compounding already negative returns for the quarter.
On paper, Global Macro strategies should be more adept at handling top-down macro driven markets than their fundamental bottom-up hedge fund peers. Yet the sheer scale and speed of market moves across multiple asset classes proved challenging. Managers focused on commodities and currencies generally fared better than generalists. Short oil and long bond positions drove gains, while losses arose from being long equity or equity-like assets (e.g. high yield).
Recent conditions have been very uncomfortable for Relative Value and Arbitrage funds. These highly technical, complex, relatively highly levered strategies are designed to exploit anomalies in market prices, harvesting returns as anomalies normalise (or persist in the case of carry-type trades); they do not do well amid sharp dislocations, high volatility and unpredictability. The broad HFRI Relative Value index reported losses of -6.5% in March, although several of the sub-strategy indices posted significantly deeper losses (Fixed Income RV down -8.4% and the carry-focused Yield Alternative strategy down over 18% for the month). This sector has historically provided relatively low volatility and high Sharpe ratios. As such, March’s drawdown will have left many investors questioning their expectations versus reality, even for a strategy know to be more leptokurtic than other hedge fund styles.
Investors should note that losses are primarily spread-based mark-to-market write-downs which have not been crystallised. Extreme market moves and illiquidity saw very significant widening in bid/ask spreads across traditionally liquid markets, causing some managers to activate redemption clauses such as anti-dilution levies or gates to protect remaining investors. While immediate mark-to-market losses have been painful in many cases, there is anecdotal evidence that investors have been using these extreme relative value trade dislocations as opportunistic entry points for deploying capital (dry powder or the proceeds of tactical rebalancing).
Manager performance should also be examined with care: some have posted losses of much more than 20%, while others have delivered positive returns. Better results were predominantly from names that straddle the Relative Value and Macro spaces, rather than pure RV approaches. Within RV, it is important to differentiate general RV from explicit Long Volatility strategies (or Volatility Arbitrage strategies with a long volatility bias). Such ‘tail protection’ strategies are explicitly designed for March-like scenarios, and the majority appear to have delivered on that promise with monthly returns of around 10-20% (HFRI Volatility index +5.7%), and materially higher in some cases. Despite these strong returns, we do not forsee greater interest in these strategies: as far as investors are concerned, they have ‘done their job’ in the near term; in any case, such allocations tend to be the result of high-level strategic decisions.
Like many of their hedge fund cousins, Alternative Risk Premia strategies were also unable to escape the aggressive risk-off sentiment that swept across markets. bfinance’s proprietary composite of ARP managers saw losses of almost 6% in March – the worst monthly result in ARP history. “Academic” ARP strategies, which exploit well-documented premia (e.g. value, carry, momentum) in market-neutral formats, lost 4.4% on average. Strategies featuring “Practitioner” premia (e.g. merger arbitrage, trend following, volatility arbitrage and seasonality/flow) fared worse, delivering -8.4% on average.
In terms of premia, the most prominent detractors included Equity Value, FX Carry, Short Volatility and Merger Arbitrage. Equity Value (a core risk premium for almost all ARP strategies) extended its multi-year drawdown. FX Carry struggled as demand for lower-yielding, safe-haven currencies such as USD and CHF increased. Equity Carry also suffered as companies cancelled or deferred dividends to protect balance sheets. In Fixed Income Carry, multiple managers were hurt by short Canadian government bond trades. Certain premia did better, albeit not enough to offset overall losses. Momentum (cross-sectional trend following) was typically positive across all asset classes, especially Fixed Income Momentum, with treasury positions benefitting from aggressive Fed-led yield compression. Commodity Momentum saw gains from precious metals (gold), which rallied strongly despite a temporary snap sell-off mid-month. Equity Quality and other more defensive equity premia also typically contributed positively.
Many ARP strategies have elected to incorporate directional (time-series) trend following premia within their ARP programme, which also contributed positively to performance. Indeed, the inclusion of Trend appears to be the key differentiator between stronger and weaker performers in March.
During a dismal period for anything that looked like a risky asset, it is unsurprising that the very diverse Multi-Asset sector delivered negative performance in March. That being said, average losses were contained to the mid-to-high single digits and certain strategies delivered some impressive capital preservation. The relative speed with which strategies measure risk (and therefore rebalance portfolios) was a key driver of returns, given the very rapid increase in volatility across all asset classes: those that are more reactive or use shorter lookback windows were able to cut exposures during the weeks of heaviest losses.
The Multi-Asset space features several distinct strategy groups. The strongest results, on average, are found in the Absolute Return Multi-Asset space: although the “GARS” subset is sometimes maligned, these strategies lost only 2.1% on average, demonstrating a bright spot of resilience during a period of high turbulence across all asset classes. These managers typically have low equity directionality and explicitly aim to avoid an over-reliance on risk assets. At the other end of the spectrum, the long-only Traditional Balanced sub-set endured a tough quarter: managers lost well over 10% on average, with extra punishment for anyone who had diversified away from US large cap growth equities and government bonds.
Unconstrained Balanced strategies did somewhat better (average -5%) than Traditional Balanced; some even delivered positive returns in March, typically driven by options-based protective positions. Several prominent managers in this space held a sceptical stance towards post-GFC market expansion, which contributed positively to results. “Diversified Growth” strategies, meanwhile, lost 8% on average, with those lacking bond exposures doing rather worse. Risk Parity managers lost 7% on average, helped by their exposure to interest rates. The better performers were those that had moved away from classic risk parity implementation, preferring a higher level of dynamism with, for example, trend-following-based tactical overlays.
Overall, we expect that the results achieved by multi-asset managers through this period will support a continuation of strong investor demand for various sub-strategies within this group: this appetite has been a distinctive trend in recent years.
According to a recent bfinance poll of 260 investors, a significant minority have not been satisfied with the performance of liquid alternative strategies including hedge funds in Q1. Investors and asset managers must now utilise contemporaneous empirical results to improve their understanding of liquid alternative strategies, rather than relying on previously assumed knowledge or past experience. As with 2008, it is highly likely this will result in changes to investment philosophies, processes, and portfolio allocations.
Commentary
Issue 148
Liquid Alternatives
Did hedge funds, multi asset and ARP deliver for investors in Q1?
Dr. Toby Goodworth, Chris Stevens and Pravir Sharma, bfinance
Originally published in the April | May 2020 issue