Man FRM Early View

January 2017

Originally published in the February 2017 issue

At the end of last month’s piece we concluded with some gnomic optimism about hedge funds’ alpha this year, and as this may have come as a surprise, we thought to pick up where we left off.

In recent years, Central Bank policies have dominated the developed markets. Since the European Central Bank (ECB)’s decision to expand their asset purchase programme two years ago, these policies have been aligned to the point that asset class correlations moved up to levels last seen in the aftermath of the Global Financial Crisis, significantly above the levels that prevailed almost without interruption between 1991 and 2007. As a business, Man cares about CTA performance, and consequently keeps a sharp eye on this correlation, because when it is low, CTAs have historically done better, and some of their worst years coincide with the higher levels. It isn’t hard to see why this relationship persists: low correlation means that volatility-scaled portfolios can run with more exposure because diversification is higher. Well, with synchronised central banks the markets were monothematic, macro opportunity was thin and CTAs did poorly.

But this problem also hit single stock alpha. This may have again been driven by the macro backdrop, as there was evidence of both higher levels of factor correlation and a stronger relationship between macro factors and individual stock prices. But there is a credible argument that the more important connection was to the repressed bond yields at the heart of the Central Bank policy. With many risk-free rates at or below zero, the core valuation techniques which discount future cash flows from equity securities were undermined, both in terms of earnings to the company and dividends to the investor. Was it a coincidence that so many hedge funds, who use these techniques, found that they often held the wrong portfolio last year? Cheap stocks got cheaper, expensive stocks more expensive. Add to this the higher level of exogenous shocks to the valuation process (OPEC, Brexit, Trump), and the result was low breadth in markets, high levels of intra-market correlation and factor dominance in stock returns – the worst kind of environment if you’re trying to be smart about picking stocks.

Our optimism for alpha opportunities in 2017 comes from the new divergences in Central Bank policy and an increase in the number of sovereign bond markets offering materially positive rates of return. Unlike a US growth forecast, which has to balance the benefits of fiscal stimulus against the risks of protectionism, the inflation forecast is arguably positive in both scenarios (fiscal stimulus in a time of full employment leads to wage growth; border taxes and tariffs push up the price of goods). With higher inflation expectations comes a steeper, higher yield curve and a more reasonable foundation for discounted cash flow valuations.

The early evidence is promising. US equity long/short managers started to report better pricing (and better performance) through much of the second half of last year as yields began to rise. In particular, quantitative models of the equity market started to show that “value” signals began working as a source of alpha at broadly the same time. And as inflation expectations have continued to increase, particularly in Europe, we have seen more positive performance from equity long/short managers in January 2017, with many commenting that the earnings season has been positive and that the market is pricing relative information more rationally. This is despite largely range-bound markets, suggesting much of the return is from alpha rather than beta.

To be clear, our views on single stock alpha are driven by the yield curve and still vulnerable to exogenous shocks of the kind that exacerbated last year’s problems. But we think a call on the level of the equity markets is more vexed. No one has tried before to run the US with the same dispatch as one might a large company. Where the parallels are real (in the domain of business perhaps?) we might see refreshingly rapid progress, but where they are less so, the early evidence is that we could hit real problems. Currently, the resurgent confidence evident across wide sectors of the economy is bridging the gap between expectation and implementation, but a reversal of this sentiment could quickly become the mechanism by which problems with new social policies feed back into the business world. Pricing at the moment indicates that the new unpredictability of policy could end well, but this can change fast.

In wider focus, developments on global trade matter. We believe the recent direction of the Brexit story is not good for either Europe or the UK, as we are now particularly sensitive to the need for a harmonious world in which new trade deals can be struck quickly. We could hope that the current hostile style of negotiation involves a lot of posturing but on this our optimism runs out. And whatever you think of the new president’s style, harmonious it isn’t.

The Dow Jones Index broke above 20,000 in euphoric mood on 25 January and held the break for three days. As we write it sits below the level again. A number of other important markets are also suffering what looks like a false break and from a technical perspective look less healthy. So, in a thoroughly contrarian spirit, we expect a potentially stronger risk-adjusted returnto alpha than to beta in these markets, at least until everything changes again.

Hedge funds
January was a positive month for hedge fund returns across a number of strategies, with equity long/short, credit and relative value strategies generating positive performance. Returns from macro managers, both discretionary and systematic, were more mixed.

For equity long/short managers, many reported more positive returns to alpha when compared to 2016, as managers with lower net exposure generated some of the better returns. Europe was noteworthy, perhaps reflecting the greater bounce from more disappointing returns last year, but returns from the US and Asia were also positive in aggregate. The earnings season has been a fruitful source of alpha, with companies generally performing in line with managers’ expectations and share prices reacting as expected to good or bad news.

It was also a positive month for statistical arbitrage managers, with performance generated across major strategy types, and all main regions. Fundamental strategies seem to be among the best-performing managers in January, a turnaround from 2016 when they were generally among the weakest strategies. Europe looks to have been a notable region for the strategy, with both momentum and valuation metrics contributing positively. Asia was perhaps the one region which didn’t recover its weakness at the end of last year – there are some suggestions that there may have been a deleveraging in the space that impacted the region. Technical managers were also able to generate positive returns in January, as were managers trading fast futures strategies.

In event arbitrage, deal spreads saw some widening. Policy and regulatory transitions of the new US administration are in their earliest days post-inauguration, causing some uncertainty. For example, reports on renewed antitrust remedy challenges to the Rite Aid deal widened that spread, while the leadership transition at the Federal Trade Commission has not even commenced. Similarly, new legal challenges facing Qualcomm cast some uncertainty on the NXP deal, and the January court ruling against the Humana/Aetna deal (which faced an antitrust suit last summer) was again in the headlines. Deal flow month to date has been lighter versus the Q4 2016 pace at about $226 billion (Bloomberg), including $70 billion of “proposed” deals. Notable deals included J&J/Actelion ($30bn), Luxottica/Essilor ($24bn stock), Zodiak/Safran ($10bn cash) and VCA/Mars ($9bn cash).

Corporate credit managers (credit long-short and credit value) generally posted positive returns in January. It was another positive month for floating-rate financial preferreds on continuing demand for financial as well as floating-rate risk. Credit value managers saw noteworthy returns from some legacy (media sector) as well as recently emerged post-reorg equities, and benefitted from continued progress in one of the large legacy bankruptcy situations in the gaming sector. Performance for credit long-short managers was driven by outright stressed/distressed credit positions as well as capital structure arbitrage trades in the energy sector.

Structured credit managers were also positive overall on the month. Managers with a larger allocation to collateral loan obligations (mostly 2.0 BBs) outperformed in January. Otherwise portfolio carry continued to be beneficial and managers saw mark-to-market gains across most sectors. Hedges, similar to the past few months, continued to be a drag on performance. Convertible arbitrage managers, given the positive equity and credit market backdrop, were also generally positive in January.

Managed futures managers delivered negative returns in January, driven by poor performance in FX, commodities and fixed income, partially offset by gains in equities. In FX, managers entered the month net long USD and exhibited losses as the dollar sold off meaningfully against most other currencies. Short EUR, short GBP and short JPY were all detractors; long AUD and long NZD were contributors. Equities saw meaningful gains this month with positive returns in North America, Asia (excluding Japan) and Europe being the biggest drivers. In terms of positioning, the biggest area of risk for managed futures managers at the moment is equities, where managers remain net long across the board, particularly so in North America and Europe. In FX, managers continue to be net long USD with short EUR, short GBP and short JPY, and long AUD and NZD being the main areas of positioning. In rates, managers continue holding a net paid bias largely driven by paid positions in the US and Australia and partially offset by received positions in Germany and the UK. In commodities, managers are net long industrial metals, grains, livestock and softs, and net short precious metals.

Discretionary macro managers had a modest month in January relative to the positive months of Q4 2016 – some managers with more robust FX exposure suffered losses as the USD reversed course against most developed market and emerging market pairs, although these moves were tempered somewhat towards the end of the month. Rates, on the other hand, maintained their upward trend, as Federal Reserve (Fed) President Yellen delivered hawkish guidance in a mid-month speech suggesting the Fed stood ready to hike rates at a faster pace than currently priced into the forward curve, and ECB’s President Draghi pointed to heightened inflation pressures while maintaining the current stance on quantitative easing. Managers remain long USD against the majors as FX remains the most concentrated risk exposure – this detracted significantly as the USD weakened steadily through the month. Some managers have reduced risk in FX on the year. Fixed income exposure remains generally stable, with short US rates/steepening bias, and managers benefitted from the US rates sell-off following the Fed speech mid-month. Elsewhere, exposure in G4 rates was mixed, with paid UK rates contributing while longs in German/Italian bonds detracted.