Man FRM Early View

June 2017

Originally published in the July 2017 issue

As John F. Kennedy said in his state of the union address in 1962, “The time to repair the roof is when the sun is shining”. With eight years of quantitative easing still compressing yields and inflating valuations, the sun still seems to be shining on pretty much all asset classes. In the first half of the year passive exposure to equities and government bonds returned 7.1%1 and 4.5%2 respectively. But confidence among asset managers in the sustainability of this move in risk assets appears stretched. The recent 20% peak-to-trough decline in the oil price has reopened the cracks in the high yield market, undermining expectations in credit more generally, but the government bond move speaks of a deeper unease. US 2yr notes are close to the highs in yield on the year, while the long end has rallied, flattening the curve by some 50bps since March.

In the very big picture, we believe forward returns on traditional assetssimply do not square with the needs of ageing populations, but there are also concerns in the shorter term. A notable and rising proportion of our clients are thinking about ways to help protect against future volatility (the vogue terms are ‘Crisis Risk Offset’, ‘Tail Risk Protection’ or ‘Crisis Alpha’). We believe that this kind of fixing the roof deserves closer attention.

Many investors have cautionary tales to tell about their attempts to run hedges, us included, and there is a traders’ saw that if you have a risk you don’t like in your book then you should sell it rather than hedge it. Why the adage? Hedging introduces basis risk, is expensive, and isn’t an efficient use of capital in a finite balance sheet in our view. But portfolio structure for a big asset manager is usually a bit less tractable than of a proprietary trader, and many investors can’t just sell their equities. Hence the current resurrection of interest in protection strategies.

Assuming one can’t call the top of the market with any great precision, equity puts run on a passive basis are notably expensive. So we believe one has to look away from directly hedging the exposure, and look for potential returns that you believe to have no coincident tail with equities, and so begins the horse trading of cost against potential dependability. What about looking to the bond allocation? While bonds may indeed have been negatively correlated with stocks this century, this has been in the context of secular deflation and an associated bond bull market. For the previous two and a half centuries, the correlation between bonds and equities has generally been positive, and therefore our confidence in a lack of coincident tail is less than certain.

If the approach has to be passive, then levered bonds at the front end of the curve may be a better option in our view than long at the back as the carry may be better and the curve has the potential to steepen in stressed conditions.

But many of these large and shrewd investors are investigating active strategies seeking to address the problem. Systematic trend-following strategies have historically offered the potential for defensive value because if markets keep going down, they will go short, sooner or later. Not many managers dream happily of 2008 but for these managers it was heavenly. Some worry now that it won’t work as well if such a crisis is triggered by a rise in bond yields, or if the drop is precipitous and comes out of the blue when these strategies are still long equities. The fear of a sheer drop is perhaps greater now that so much market-making capital has been drained out of the system and liquidity is more dependent on simultaneous order matching. One option that we are closely investigating is Systematic trend-following with capped equity exposure, which helps reduce the gap risk and redistributes exposure in other asset classes.

We believe another option may be to look for equity long/short managers with a distinctive ‘quality’ bias in their universe. The quality factor has historically performed positively during market crises as investors’ flight-to-quality impulse applies as much within asset classes as it does between them. If one is able to find an equity long/short manager with a quality bias who is able to also add alpha in non-crisis periods, then we think this could potentially be an attractive option.

However, perhaps the most important question when thinking about hedging is what to do if it pays off? In the midst of a crisis, the value of one’s hedges will hopefully expand materially and exhibit lots of gamma. If one doesn’t have a plan – and many, we think, haven’t – as to when and how to crystallize, and how to reallocate the proceeds then the benefits of such a program could potentially be lost, with only the costs to remember it by.

From the hottest June day in Britain in 41 years (June, 21) the weather in London has now reverted to its traditional hallmark, the cold shower. With potentially overvalued assets, a difficult budget negotiation ahead in the US, and an extremely weak UK government muddling through Brexit, it may be that summer is also approaching its end in financial markets. And so we are back with John F. Kennedy’s advice about building maintenance, though even that is a more straightforward exercise than the hazardous game of seeking downside protection in financial markets.

Hedge funds

June was a mixed month for hedge fund returns, with equity long/short and relative value strategies generally performing positively on increased single security alpha, while credit and global macro struggled. Credit was hurt by the fall in the price of oil and associated impact on high yield markets, while many global macro managers saw a favorable month evaporate in the last week of the month as bonds sold off sharply.

In equity long/short, European managers generally saw their positive alpha from May continue into June, as many managers reported positive returns despite flat performance from market indices. The key driver of return continues to be earnings announcements and the more rational reaction of share prices to good and bad news. Our managers believe that markets have been less driven by passive flows and factor driven investing over the past two months, which has allowed individual share prices to behave more in line with fundamentals.

US based equity long/short continues to generate less alpha than their European counterparts in our experience, but the US market indices outperformed other developed markets in June, which helped to support hedge fund returns in general. In addition, larger and more traditional US hedge funds tend to have performed better. Over the first six months of 2017, the Goldman Sachs Hedge Fund VIP Index (which tracks the largest long holdings of US equity long/short funds) returned +13.5%, outperforming the S&P 500 Index return of +8.2%; as at June, 30 2017.

In event driven strategies, merger arbitrage dedicated managers had a favorable month as spreads generally tightened throughout. One pharmaceutical company was a leading detractor in this space, as a takeover bid failed to secure enough shareholder acceptance. Managers remain generally positive on current live deals, though deal flow was relatively muted in June again, with $220bn of deals announced (excluding proposed deals) and few >$5bn deals.

Activists continue to be in the headlines (for better reasons than last year, thus far). Whole Foods (held by activist hedge funds) received a bid from Amazon this month. In the meantime, Dan Loeb at Third Point announced a large stake in Nestle urging the company to consider slimming down as well as buying back its stocks, the latter was announced a few days later. Asian based relative value funds generally lagged in June, as the much anticipated MSCI Inclusion for Chinese A shares generated fewer alpha opportunities than many managers had hoped.

Statistical arbitrage had a better month than in May, particularly as mean-reversion strategies generally rebounded from previous poor performance. The strongest factors driving fundamental strategies were value and momentum – given that these factors can often offset one another, it is historically indicative of positive performance when they work in concert. Futures strategies performed well through the first part of the month, but gave back some of the gains in the final week.

Managed futures strategies saw a positive month evaporate in the last few days of the month as bonds and equities both pulled back, since managers have been long both asset classes in recent months. Commodities generally added value, with short positions in oil and other energy futures performing positively through the month. FX exposure generally detracted from performance, as many managers came into the month with broadly net long USD exposure, which subsequently sold off.

Corporate credit manager returns were once again mixed in June. Several managers reported losses on long energy credit and recently emerged post-reorganization equity positions which were only partially offset by commodity and public equity hedges. The stub trade of one internet services company was also a detractor for some managers as the sale of the company’s core business to a telecommunications company finally closed, leading to selling pressure from index funds as the former was removed from the S&P 500 Index. An online marketplace (the short leg of this trade) also reported robust earnings in June.

Corporate credit managers reported mixed performance in financials, with the US financials focused managers continuing to build on YTD gains. Managers had a mixed fortune in a bank where the regulators unexpectedly arranged a sale resulting in the equity and junior debt getting wiped out.

Structured credit managers generally outperformed corporate credit managers in June as the carry-driven gains continued. The credit curve was also flatter, supported by the sustained demand from yield-starved investors. Convertible valuations on a dollar-neutral basis were somewhat mixed in June as convert equities outperformed and investment grade credit was positive while high yield spreads were wider depending on the name.


1. MSCI World Free Local Currency Index; as at June, 30 2017
2. Citi World Government Bond Index; as at June, 30 2017