Man FRM Early View

May 2017

Originally published in the June 2017 issue

In hedge fund land we use the ‘Sharpe ratio’ to quickly assess the quality of an investment. It is calculated as the return from the investment, in excess of interest rates, divided by the variability of that return. Higher is clearly better. In late May the 5yr annualized Sharpe ratio of the S&P 500 Total Return Index exceeded 1.5. In other words, over the last five years US Equities paid you 15.3% per year to bear an annualized monthly volatility of returns of 9.9%. Over the past 30 years, the 5yr Sharpe ratio has seldom been higher (it has exceeded 1.5 only three times since 1987, and in each case only by a small amount), and the volatility seldom lower (annualized volatility has been lower than 10% only twice over the same timeframe).

Remember that global government bonds have also been in a 30 year bull market, and therefore pretty much any mix of traditional assets has performed well for the best part of a decade. It is not surprising that some investors have looked at the relative underperformance of active strategies, particularly hedge funds or managers without an explicit benchmark, and concluded that they aren’t worth the hassle. Is it any wonder, therefore, that investors are moving out of active investments and into passive replication strategies at a record rate?

It is hard to forecast how this fundamental shift to passive investing will affect the ability of the remaining hedge funds to extract alpha from markets. In a static world it seems to be a positive – to the extent that new information represents a potential opportunity to generate excess return through non-benchmark positioning, then fewer active market participants could mean a bigger slice of the pie for the remaining players. But we don’t live in a static world. In recent years the size of the flows into passive funds and ETFs has led to sharp swings in market factors that have little to do with fundamental valuation, which has made active investing more difficult. We believe that in the event of a market crisis, a large flow out of passive investing could be even more chaotic.

A related issue for active investors is the increase in assets managed by quantitative investment programs. Again, here there are opportunities and threats. ‘Smart beta’, which looks to replace indices with something that delivers a slightly higher quality return, in our view, only exacerbates some of the issues associated with increased passive investing. Similarly, the trend towards artificial intelligence and machine learning algorithms threatens to place increased weight on pattern recognition strategies, which may lead to markets becoming ever more technical in nature (i.e. driven by past price behavior rather than fundamental information).

However, don’t forget that some of the most innovative quantitative market participants are hedge funds, both in the statistical arbitrage and managed futures communities. These funds are able to use quantitative breakthroughs to better extract information from the growing mountains of data that characterize the investment landscape of the early 21st century, and this we think should improve the quality of their returns.

All of this leaves us feeling that the active management industry finds itself at an important juncture. We are confident that hedge funds remain nimble enough to deal with the challenges of the changing investment landscape, and we are starting to hear managers talking of two ways to help navigate the next few years, i) extend time horizons of individual trades, using short term price dislocations and securing better entry points, and then having patience and increasing risk tolerance to sit through volatility until prices revert to a more fundamentally sensible level, and ii) to focus on more niche strategies/areas, such as smaller-capitalization stocks, emerging markets, and capital market events (IPOs, mergers, spin-offs etc), which tend to be outside of the scope of passive or quantitative market participants, and have arguably become more lucrative as the active management share of the market has dwindled.  

Of course, if we truly expect equity markets to continue to deliver a Sharpe ratio of 1.5 forever then we (and most of the hedge fund industry) should probably just give up now. However, we think that recent period is an aberration relative to the long history of equity markets, supported by the extraordinary monetary policy of the last eight years. Over the past 100 years, the S&P 500 Total Return Index has delivered a Sharpe ratio of 0.4, so we don’t believe this current period is sustainable ad infinitum.

More broadly, we continue to think that the case for active management is stronger when we have more normal levels of volatility in risky assets and more normal levels of government bond yields. And we believe that the gradual end to extraordinary monetary conditions across much of the developed world should see both of these materialize, since neither is representative of healthy and rational market pricing in our view.

But calling the turn on any of these areas is tricky – May was a good example. Despite growing concerns over the stability of the Trump administration, which saw the VIX Index increase by 50% mid-month (albeit from 10 to 15) equity markets recovered in the space of two days, volatility quickly dropped back to its very low base, and government bond yields continued to fall throughout the month. To borrow from Keynes, the market can stay irrational for longer than you can keep making excuses for active management underperformance.

Hedge Funds
May was, broadlyspeaking, a positive month for most hedge fund strategies, although returns continue to be subdued by range-bound markets and a general lack of volatility. The better performing strategies included equity long/short, particularly in Europe, structured credit and some relative value strategies. Managed futures and statistical arbitrage generally produced negative returns.

May witnessed several risk events that were unanticipated, including a political corruption probe in Brazil as well as US political volatility. Notwithstanding the brief spike in the VIX mid-month, market volatility continued to compress, causing global macro managers to maintain modest risk profiles. Performance from global macro was modestly down overall in May, with continued unwinding of post-US election catalyst trades hurting managers who maintain shorts in US fixed income and longs in USD.

Emerging markets continued its robust run, with inflows into emerging market equity and debt funds net positive, and the MSCI Emerging Markets Index up over +3% despite the mid-month uncertainty surrounding Brazil and the China debt downgrade by Moody’s, and the immediate contagion effect in broader EM markets has been relatively muted. Managers remain bullish overall on emerging markets given the improvement in balance of payments conditions and improving growth outlooks. Long positions in emerging market fixed income as well as Brazilian equities, however, hurt managers on the month. With respect to China specifically, global macro managers have exhibited a relatively benign view on corporate default risks and also the potential for political instability, particularly ahead of the 19th National Party Congress meetings in October.

In developed market rates and FX markets, volatility has been spiky around European elections, and managers have been optimistic about potential opportunities in basis and curve trading in Europe as dispersion remains wide. Global macro managers have retained more substantial exposure within the fixed income sector, as outright shorts in US rates detracted in May. While the futures market implies over 90% probability of a Fed rate hike in June, there is a divergence for later dates suggesting asymmetric risk reward. Looking ahead, upcoming European Central Bank (ECB) meetings have the potential for multiple policy changes, including revised forward guidance as well as whether the negative target rate might be removed, and importantly some clarity on the sequencing issue – how the ECB will tackle scaling back of various elements of its quantitative easing program and its deposit rate facility. As such fixed income markets could potentially provide a ripe environment for trading within the global macro community in the coming quarters.

In equity long/short, May was a welcome return to alpha for a number of managers. In Europe, markets were broadly flat on the month, whereas hedge fund managers generally produced positive returns. At the margin, trading focused managers and more market neutral managers did better. US based managers were more mixed, but also tended to generate positive returns on average. Asian equity long/short generally performed well despite increased volatility in the region. Japanese managers report that the market generally traded in line with valuations during the month. Pan-Asian managers were helped by the robust performance of the Hang Seng Index, particularly in how quickly Chinese stocks shrugged off the sovereign debt downgrade by Moody’s in the middle of the month.

Event-focused managers also produced positive performance in May. Risk arbitrage contributed positively, as spreads tightened in deals around NXPI and RAI, and the Syngenta/ChemChina and Actelion/J&J deals closed. Spreads tightened in a fairly linear fashion without being impacted by market swings, which generally indicates a positive environment for the strategy. Average unleveraged Internal rate of return (IRR) on risk arbitrage books is around 10%, down a couple of points from a month ago, suggesting that the size of the opportunity remaining in event strategies is reducing.

In credit, manager returns were somewhat mixed and muted in May with a few exceptions. With support from rates and equities, modest flows, and a continued light new issue calendar, US high yield bond yields and spreads remain close to multi-year lows. Most US high yield sectors were once again positive for the month. After underperforming in April, the healthcare and utility sectors were notable performers in May driven by positive fundamental news and events. Lower-rated credits seem to have outperformed higher-rated names in May after underperforming in the previous two months.

Credit managers focused on financials continued to post robust returns. Trust Preferreds were a bright spot in the month as the market repriced higher after Wells Fargo called a floater at par. Parts of the Puerto Rico municipal debt complex did well as the Commonwealth began the restructuring process allowed under Title III of the PROMESA legislation. Commodity-related post-reorganization equities that were generally weak over the prior few months stabilized and generated gains for a number of managers.

Structured credit managers were mostly positive for the month as there was a continued strong bid for legacy residential mortgage-backed security (RMBS) and collateralized loan obligation (CLO) paper. Spreads were also firm across most other securitized products sectors. Convertible valuations also improved in May driven by underlying stock performance, tighter spreads and a modest intra-month increase in realized volatility.

Managed futures managers generally struggled during the month. The pattern of recent months continued, with long equity positions across most regions contributing positively, while other asset classes have been a detractor. The equities gains were broad, with Europe, Asia, US and the UK all contributing positively. The overall equity exposure in the strategy remains at elevated levels, with the US the largest position followed by Europe and Asia.
In terms of detracting positions, commodities have been the largest detractor for managed futures. This was largely driven by short positions in the energy sector, and shorts in grains, though there were losses across sub-sectors. In FX, losses have generally come from short positions in CAD, NZD, and NOK, while long EUR exposure has offset some of these. Fixed Income has been a negative driver this month, largely driven by receiver positions in Europe and Japan. Positioning in the US is much more mixed and was a minimal driver of performance. Most managers are now long fixed Income in most regions.

In statistical arbitrage, managers generally had a poor month. Those managers with a Futures strategy have struggled in line with managed futures. In fundamental quantitative equity investing, it’s not easy to pin down a particularly obvious driver, with the factor indices not showing any particularly painful areas. A number of our managers have commented that the market behavior during the month was indicative of a large investor liquidating their quantitative portfolio, but we don’t have direct evidence of this.