Detecting investor themes
Over the last 12 months, two major investment themes have gained traction: getting exposure to emerging markets and to global currency markets. Both themes have been mirrored on the Lyxor MAP thanks to hedge fund investors’ allocations.
First, there have been structural and cyclical motivations to increase exposure to emerging markets during the second half of 2010. The secular growth story of emerging markets has been known to investors for more than a decade. The new structural feature is that emerging market economies offer solid public finances in a world of high indebtedness. Clearly, the lessons of the 1997/98 crises have been learned and the recent economic and financial crisis has its roots in the developed world. According to IMF data, debt-to-GDP ratios in advanced economies are expected to exceed 100% of GDP in 2014, some 35 percentage points of GDP higher than before the crisis. The fiscal challenges are different in a number of emerging economies, with some important exceptions. The public debt problem in these economies is more localized – as a group, these economies’ public debt ratios are at about 30-40% of GDP and, given their high growth, are expected to soon be back on a declining path.
Evidence of this is the fact that at the beginning of 2010, more than 50% of the constituents of the J.P. Morgan EMBI Index enjoyed an Investment Grade ranking, with more upgrades likely to come. The main cyclical reason was the significant decline in economic uncertainty. The Jackson Hole speech of Fed Chairman Ben Bernanke on 27th August and the commitment to provide additional monetary accommodation through unconventional measures to avoid a double-dip recession in the US was the starting point of a dramatic increase in assets of the emerging market-related funds on Lyxor MAP (see Fig.1). Most importantly, access to emerging market exposure can be achieved in many different ways. Beyond beta-exposure, hedge fund managers have proven their ability to generate alpha over several years. Some of them are not genuine emerging market hedge funds but we thought it useful to include global resources and commodity specialists as these markets are likely to be dominated by changes in emerging market demand over the next decade.
Similarly, some systematic funds on Lyxor MAP also offer important exposures towards emerging markets and are therefore worth mentioning. The managers have access to multiple sources of alpha. Readers should keep in mind that hedge funds with exposure to emerging market themes do not solely play the secular market trend. While they tend to perform better during bull markets (by harvesting their exposure to higher beta) they can also make money in downturns, for example with outright shorts and hedges or with exposures on FX or fixed income markets. Additionally, turbulent markets often deliver pricing opportunities that will improve future performance. The emerging market-related funds on Lyxor MAP have seen their AUMs increase by 56% during 2010, accounting for more than $900 million at end-December.
Second, currency-related funds have attracted investors throughout the entire year (See Fig. 1). Contrary to most hedge fund strategies, both performance and net investor flows have been positive in the immediate aftermath of the outbreak of the European sovereign debt crisis last spring. Beyond currency specialists, we have observed that CTA and global macro funds have been increasing exposure to foreign exchange markets throughout the year (see Fig.2). Last year’s moves have occurred in markets which have registered massive growth recently. According to Bank for International Settlements data, global FX market turnover has increased by 20% since April 2007, to $4 trillion daily.
With respect to counterparties, the rise in global foreign exchange market turnover is associated with the increased trading activity of other financial institutions – a category that includes non-reporting banks, hedge funds, pension funds, mutual funds, insurance companies and central banks, among others. Turnover by this category contributed 85% to the total growth in FX markets, increasing to $1.9 trillion daily in April 2010 from $1.3 trillion in April 2007. Within this customer category, the growth is driven by high-frequency traders, banks trading as clients of the biggest dealers, and online trading by retail investors. Electronic trading has been instrumental to this increase, particularly algorithmic trading. In spite of a disappointing start to 2011 amid significant reversals in currency markets following an unwinding of positions, we anticipate opportunities for investors within the FX market in the months to come.
There are some well-established patterns but also some moves into uncharted territory. The latter, of course, are often most rewarding for market participants. Monetary policy decoupling between the emerging and developed economies as a result of higher growth and inflation dispersion should allow hedge fund managers to monetize ongoing FX dispersion. At the end of 2010, the AUM for currency-related funds on Lyxor MAP accounted for $1.3 billion, equivalent to an increase of 52% in one year.
Reading manager responses
A third major theme emerged on Lyxor MAP in 2010: the downsizing of long/short equity holdings. These funds, in particular those with a European focus, have been penalized by the sovereign debt crisis in the euro zone and the rise in correlations. As the CBOE’s VIX Volatility Index peaked at 45.79 on 20th May 2010 (at a level above the pre-2008 crisis, and levels seen in the aftermath of Russian default, September 11th, Enron and WorldCom accounting scandals), few investors wanted exposure to equities. The Irish leg of the European sovereign debt crisis in November was another hit to the long/short equity strategy, leading to a significant decrease in assets during the year (See Fig.1). Long/short equity hit a historical low on Lyxor MAP, representing just 16% of total assets, in December 2010. This number is down from a peak above 45% reached in 2007. Among these funds, European managers were particularly shunned as investors cut their risk budget on European equities.
The stretched public balance sheets and current accounts of many European states have started to translate into a worst-case debt scenario, where sovereign risk would materialize. But the great divide observed among European economies and markets should not be solely seen as a threat but also through the lenses of new investment opportunities. The march to European Monetary Union during the 1990s was marked by economic and financial convergence throughout the continent. Conversely, the impact of the Lehman collapse in 2008 led to a reassessment of risks and both sovereign bond spreads and domestic equity performances widened again rapidly. Beyond triggering immediate responses from hedge fund managers and hedge fund investors, the recent European sovereign debt crisis outbreaks go hand in hand with rising macro-financial dispersion.
Hedge fund managers with exposure to European equities do rarely position their funds in a directional way and can easily build exposures to growth themes enjoyed by European large cap stocks. Trading-oriented managers have demonstrated that they can reverse quickly whereas fundamental managers have witnessed their ability to identify less crowded trades. Let’s summarize the responses of European long/short equity managers to the latest bouts of the sovereign crisis in May and November last year. Let us remember that the market impact of the crisis in May was dissimilar, i.e. stronger, than in November. As a result, trading-oriented managers registered different performance patterns than fundamental stock pickers. And, finally, most statistical arbitrage funds were trapped by the resurgence of a European country factor, as most models are based on sector-clusters.
The outbreak of the Greek sovereign debt crisis has clearly been perceived as a time of major stress within the European long/short equity investment universe. The general movement has been a reduction of gross exposures, both in the long and short books. Trading-oriented managers have been able to change their exposures in a nimble and opportunistic way during May. These funds traded actively and took advantage of the severe volatilityin equity markets, reducing the gross exposure significantly and playing German outperformers vis-à-vis other European markets.
The main positive contributors for May registered on the short side, particularly in the high-beta cyclically-driven industrials, technology and retail sectors. Fundamental stock pickers suffered in a context in which the macro factor drove financial markets down as a whole, disregarding all idiosyncratic, stock- or sector-specific factors. The month of November and the outbreak of the Irish sovereign debt crisis were different in their impact on the market, and moves were not entirely macro-driven. Stock picking was back: the management of exposures has not been the determining factor of performance this time as inter-sector dispersion rose again and equity correlations declined. Therefore, navigating through the month of November required a different investment style than navigating through the month of May.
What are the first insights of 2011? Hedge fund investors and hedge fund managers agree that the global economic uncertainty has fallen. In this context, even the very bearish view on Europe has been tempered. Our indicators show that investor appetite for hedge funds continues at a sustained pace while exposures have been raised further at the start of the year. Money has been put back to work.
Stefan Keller is Head of MAP Research and External Relations at Lyxor Asset Management in Paris. He joined Lyxor in December 2007 as a strategist and portfolio manager. Previously, he was a senior economist at Exane and oversaw the Global Asset Allocation publication. He is co-author of the Guide des Indicateurs de Marché, published in 2008.