Man FRM Early View

February 2020

Originally published in the February | March 2020 issue


Everything from a recently arrived alien to an open-minded machine learning algorithm knows that there are two things for certain about markets: bonds go up, and every argument ends in the words ‘policy response’. 

Not much more than a week ago we were scratching our heads at how markets seemed to be both ‘risk on’ (the NASDAQ up 10% YTD) and ‘risk off’ (US 10yr bonds +3% YTD, gold +7% YTD, and the US dollar +3% YTD) at the same time. We speculated that maybe a moderate amount of tangible concern, around something like the coronavirus outbreak, was a Panglossian ‘best of both worlds’ for all asset markets, big enough to see a bit of flow into safe havens, but small enough that equity markets can rally on expectations of more central bank stimulus without being overwhelmed by the risks to growth. 

Of course, by the morning of Monday 24 February, we’d had a sharp reminder of just how precarious that balancing act really was.

Of course, by the morning of Monday 24 February, we’d had a sharp reminder of just how precarious that balancing act really was and had fallen resolutely into the ‘risk-off’ side of the equation. The S&P 500 dropped nearly 6% in two days, with many European and Asian markets down more. Less Panglossian, more pandemic. From a hedge fund perspective, the initial sell-off appears to be somewhat orderly. The initial move saw little differentiation between the performance of individual equities, as passive holders of equity indices and systematic hedge funds cut exposure. Our experience with previous sell-offs suggest that it takes a few days and a persistence of drawdown before the equity market neutral participants start to factor the higher market volatility into their models and we see deleveraging and hence differentiation within markets. It is often this second wave of risk reduction that leads to losses for active equity market participants, since (by definition) the positions that are being closed are more likely to be those that have done well recently. In the parlance of the quantitative hedge fund community, it is often pain for ‘time-series momentum’ first, pain for ‘cross-sectional momentum’ later.

Back to the market, and while the situation is still developing, it has become clear that for attempts to control the spread of Coronavirus to be effective they will be more damaging to economic activity than initially expected. In such a fast-moving situation, it is impossible to say whether the market ‘price’ for the impact of such measure is the right one. Pricing the impact of such measures on asset markets is impossible given the complexities involved, not least given the second order effects along supply chains and across capital structures of economic slowdown in certain sectors and regions.

But perhaps, as alluded to earlier, the fundamentals of the event itself are not necessarily the key driver for markets from here. If – and it is a very large ‘if’ – we reach a point where the transmission of the Coronavirus seems unstoppable globally, then we feel it is likely that the attention of investors will quickly shift from the intricacies of contagion rates and incubation periods, to the economic policy response. From the investors’ perspective, the last twelve years have seen central bankers come to the rescue of market crisis after market crisis. Hong Kong has already announced HKD10,000 cash injection to each adult citizen in a bid to stimulate growth. No wonder investors place so much weight on the central bank put – two days of falling stocks is enough to signal the start of helicopter money. Now that Hong Kong has blinked first, other countries may view this as a test case. If it seems to work, this may open the floodgates for Modern Monetary Theory, fiscal stimulus, and all the other forms of direct intervention mooted at various times across the developed economies.

And so we are (possibly – in the worst case outcome) back to the arguments of the effectiveness of policy stimulus to protect the global economy in a world already flushed with money and rates close to zero. It is apposite that the epicentre of the viral outbreak in Europe is currently in Italy. The reaction there has been for government bonds to sell off rather than rally (ditto Greece, Portugal, and even Spain) – a sign that further economic weakness in fragile states trumps the ability of policy makers to respond. It’s another reminder of the kind of second-order effects of a global economic slowdown; issues that markets deemed ‘solved’, like the Eurozone debt issues, might bubble back to the surface (especially given that the political leadership in the Eurozone is significantly weaker now than it was in 2011/12). Even for policy makers with a little more ammunition, such as the Fed or the BoE, any escalation of the current situation is likely to increase scrutiny on the efficacy of their actions.

From a hedge fund perspective, an end to the ‘QE era’ wouldn’t necessarily be a bad thing. Quantitative market neutral specialists have long bemoaned the impact of free money on dampening the return to, say, value strategies. And the broader active management community (at least those trying to generate alpha rather than beta) periodically grumbles that the central bank put has significantly reduced the breadth of market phenomena. As to timing, it would take a pretty smart alien or a very well read machine learning algorithm to know that radical things like helicopter money tend to happen in Hong Kong first and Europe last, but one of them may just have heard that old joke that when you know the world is about to come to an end, the place to go is Belgium: everything happens thirty years later in Belgium.

Hedge funds

Hedge fund performance held up fairly well in the face of a significant increase in market volatility in the final week of February. Broadly speaking, strategies that struggled during the early part of the month when equities were strong are those that performed a little better in the sell-off (such as factor-driven equity market neutral), whereas those strategies that benefited from the first three weeks of the month generally held on to some semblance of positive performance for the month during the difficult final week.

Trend followers are a good example of the latter camp. Managers were enjoying positive performance through the first three weeks of the month, as equities, bonds and the dollar were all held in long positions and all were posting positive performance MTD. The last week of the month saw significant losses (and position cutting) for the equity exposure, but the bond and dollar exposures, as well as long gold exposure, and short energy exposure provided some insulation (although not enough to avoid a material loss in the last week of the month). Over the course of the month, however, a number of trend following managers posted positive returns thanks to the strength of the first part of the month. Coming into March, managers are generally positioned much more defensively, and as such are susceptible to a sharp snap back in risk assets but should provide protection in a continued risk-off move.

Equity long/short managers generally held up well through the sell-off. Of course, managers with higher net exposure suffered from the beta impact of the market decline, but again these managers had gains from the first three weeks of the month to soften the overall monthly loss. The low net and market neutral cohort of equity long/short managers seemed to navigate the sell-off fairly well, with managers recording either small positive or negative returns for the month as a whole. One area of interest is in factor driven managers, such as alternative risk premia, who generally suffered losses in the first three weeks of the month, but then recovered somewhat during the market volatility. This phenomena was particularly true for value and quality type exposures.

Looking forward, we have not seen any large reductions in either net or gross exposures from the equity long/short universe (including quantitative equity managers). This suggests that, much like in October 2018, there is the potential for delayed deleveraging pain if the market volatility doesn’t normalise within a week or so.

In credit, it is not surprising that treasuries and investment grade credit outperformed high yield and leveraged loans; though even the performance in high yield and loans is around flat for the month, seemingly detached from the turmoil in equities. The energy sector bore the brunt of the sell-off while the telecom and cable and satellite sectors outperformed, driven by strong performance of names like Sprint (T-Mobile merger approval) and Intelsat. There were a few bright spots in the healthcare sector as well, including names like Mallinckrodt on the settlement of opioid claims.

Credit managers generally held up reasonably well in February, especially given the volatile market backdrop. Areas of outperformance included convertible arbitrage (which has been a beneficiary of the pick-up in market volatility), US financial preferreds (strong and generally stable to improving credit profile for large US banks), and US structured credit (US consumer remains in good shape; declining rates could be tailwind in the near term). Credit managers with exposure to reorg equities underperformed.

Event and relative value managers have held up well in February, with broadly flat performance, after earlier gains in the month were given back in the final week as spreads widened and more directional positions moved down. Managers’ gross exposure levels are at average levels, also as deal volumes in February are tracking to be similarly muted as January, in a sharp reversal from the strong level of deal announcements toward the end of 2019.

In positive deal news for a number of hedge fund managers, T-Mobile’s $59bn takeover of Sprint has moved forward decisively after a US District Court ruled against a lawsuit filed by more than a dozen states, led by New York and California. The merger agreement has also been renegotiated and T-Mobile parent company Deutsche Telekom will receive a bigger ownership stake of the combined company, while SoftBank will get a smaller share, reflecting Sprint’s declining financials over the last two years.