Man FRM Early View

November 2017

Originally published in the November | December 2017 issue

When does an increase in the price of an asset reflect a change in value, and when is it simply borrowing the return from the future? Did we really earn it or will we have to give it all back later? When are we assessing our reaction to profits rationally and when are we suffering from hubris? These are increasingly queasy questions. If the USD 70trn of global equities are up 15% this year, then in equities alone we have seen a repricing of asset values by around USD 10trn, or around three years’ worth of real global GDP growth. Was this earned or borrowed?

Of course, we know our colleagues in the asset management industry are mostly heroic, but the idea that we have somehow unearthed an extra three years of global GDP growth is something the pusillanimous world outside is struggling to appreciate. Last month, one highly credible asset management research group showed their ten year forecast for a ‘balanced portfolio’ to be lower than any they had ever previously seen. This may suggest that at least some of the gain is ‘borrowed’.

Returns have come fairly easy to most long-only investors this year. The S&P 500 has gained 17% or so with a couple of c3% drawdowns. Compare that with 2016 when a 13% drawdown was rewarded with a 9% return, or 2015 when you had a worst loss of 10% and a loss on the year. Meanwhile, the Barclays Capital Global Aggregate Bond Index has returned +7% YTD, the best year since 2007. That can’t allbe coupon payments, so given USD 40trn-odd worth of global bond assets, perhaps we found something closer to four years’ worth of real global GDP growth in long-only asset revaluation this year. This is exhilarating stuff.

Hedge funds are having their best year since 2013, and the breadth of return across strategies is impressive. We believe that in most hedge fund portfolios the two key risks to watch are first the implicit net exposure to equities (meaning both the explicit net equity beta plus the other risks that correlate to equity) and second ‘momentum’. Neither is easy to measure dependably but momentum is particularly difficult, as it spans multiple forms (outright or ‘time series’ momentum and relative or ‘cross-sectional momentum) and multiple time frames. The time to get serious in thinking about these two key risks is when both readings are high and correlated. Is that now?

Industry wide CTA returns (ie strategies managed to capture time series momentum) are nothing to write home about this year, so one might think that ‘momentum’ risk is not that high. But in the critical question of equities, there are a few words of caution to add.
First, CTAs scale their positions inversely to historic volatility, so most have much larger long positions in equities than they would if markets had been more difficult. You might think of this as the computer’s way of doing hubris.

Second, in cross-sectional equity momentum, that is, outperformance of securities exhibiting momentum vs those that are not, returns have been attractive, particularly in the second half of the year. Bear in mind that equity trading is still the largest piece of the hedge fund universe and that cross-sectional momentum is their largest risk after net equity. So are the risks high and correlated? Indeed they are.

Hedge fund gross market exposures, or leverage, remain elevated, and if anything have edged up throughout the year. This current positioning hangs on a delicate balance of factors: (1) Volatility needs to stay low, or the scaling of risk will go into reverse; (2) Correlations have to stay low. This is critical for the same reason. High correlation implies higher portfolio volatility which requires de-leveraging. Bond-equity correlation has been particularly low for the last 20+ years, leading to larger exposures; (3) Momentum has to keep going, or people may start taking profits which could lead to an unwinding of momentum trades more generally. The interconnections here are robust. If any one of these heads in the wrong direction it could take the others with it. And deleveraging can be like kryptonite for hedge funds.

But consider this scenario. Short end yields have been rising in reaction to the end of QE, but the long end remains stubbornly low. So, in a last ditch effort to keep up with benchmarks, which look ever less achievable by conventional means, we see the asset management community forced out of low risk assets into ever larger equity allocations. This drives equities up some more, but allows bond yields to reprice to more historically normal levels. Central banks gain more room to react to future growth shocks, and the correlation between equities and bonds remains firmly negative, so leverage levels stay intact. Equity valuations go up dramatically, of course, but that’s why you don’t try to fade momentum so long as it stays steady. We believe that’s the real moral of the 2017 story so far.

So while the mood in asset management to us actually feels more entitled or complacent than euphoric (and is therefore perhaps all the more suggestive of hubris), imagine that we add another couple of years of real global GDP growth and then switch into bonds at a more normal yield. Then we really would be heroes. Sound implausible? Quite so. Not for the first time, our strategy is to try and react rather than predict, but react fast.

Hedge funds
November was a positive month for equity long-short and CTA strategies, and mixed to negative for credit, discretionary macro and relative value. The best performing factors in markets were momentum (both at the security level and asset class level) and short volatility (particularly around the drop back in implied volatility through the second half of the month).

In equity long-short, the best performing region was Europe, where managers continued to build on a positive year for alpha. As noted above, the key driver here was single stock momentum, and the best performing managers in November were those who have had positive performance over the last few months. We saw a similar phenomenon in Europe in periods such as August 2013-February 2014 and June 2015-December 2015. Both of these periods ended with a momentum reversal which saw losses across many European Equity Long-Short managers. Asian and US managers had mixed performance on the month.

In macro markets, global sovereign yields and the USD trended lower on the month, with dovish central bank rhetoric from the Fed (Federal Reserve) and the ECB (European Central Bank) amid concerns about a weak inflation outlook. This has kept a cap on yields in the near term, and had a flattening effect on the US yield curve, with the 2s10s US Treasury curve flattening 20bp to the lowest levels since 2007. Despite this, the market is all but fully pricing for a December Fed hike (96% probability). Emerging market currencies continue to be supported by ample global liquidity conditions and low real rates in the US, as well as global growth momentum, propelling the emerging market FX index to YTD gains of nearly 5%.

Overall discretionary macro managers suffered losses in November, as many managers continue to hold shorts in developed market rates. FX trading remains one of the more tactical asset classes for global macro, although several hold thematic shorts in KRW as a geopolitical risk hedge, and also shorts in JPY on the expectation of continued accommodation from Abe. Longs in gold as a risk hedge position also benefited on the month. Oil prices broke higher on healthy global oil demand and OPEC maintaining production targets steady through 2018. Global macro managers have diverged on crude forecasts. Managers continue to employ a portfolio tilt towards relative value constructs, as global spread trading and cross-market trading has provided a potential opportunity set in the context of monetary policy divergence.

November was also a challenging month for event driven strategies. The highlight, albeit negative, was Time Warner/AT&T. News flow began to circulate in the first few days of the month that the Department of Justice had antitrust concerns on Time Warner, despite this being a vertical merger, causing the spread to widen significantly. As Time Warner/AT&T was generally one of managers’ largest positions, the pain was relatively severe. Later in the month the Department of Justice filed a suit to block the deal, though that was pretty much baked into the price already. Managers have generally trimmed their position in the deal slightly, but the general consensus is that this deal will get done. Sky and NXP were also in the news, but the net P&L impact of this deal was smaller. Overall merger spreads widened a bit throughout the month.

With 2017 coming to a close, M&A (merger and acquisitions) activity is accelerating. Deal activity reached USD 390bn in November including USD 205bn of proposed deals (Bloomberg). Transactions worth USD 10bn+ increased over the past month, driven by: (1) increasing confidence in global economic conditions; and (2) the looming threat from super-corporations like Amazon. Special situations outperformed merger arbitrage in November. And, European managers generally saw positive alpha from their equity and credit softer catalyst situations.

For CTAs, November was a positive month. As in the last two months, equity has been the main driver and hasgenerated the bulk of the gains. The performance has been driven by Asia (including Japan) and North America, while Europe excl. UK has been the only detractor. Net exposures remain long across regions.

Fixed income has contributed positively, while commodities have been flat and FX has detracted marginally. The performance has been driven by short positions in US Treasuries and long positions in Japanese, French and Italian Government Bonds. Short positions in Canadian and long positions in German Government Bonds, however, have detracted this month, while commodities have been flat. The gains in Energy (Oil and Fuels) have been offset by losses in agriculture and livestock. Interestingly there has been quite a bit of differentiation in commodity performance this month. In line with last month, FX is the only asset class that has detracted on a month to date basis. This has been caused by a net long USD position.

It was another month of underperformance for corporate credit relative to equities. Corporate credit spreads widened through mid-month among heavy outflows from US high yield bond funds before recouping most of the losses by month-end as outflows subsided. The loan market was also somewhat soft as issuance was robust, driven by re-pricing and refinancing activity while loan funds saw outflows as the yield curve flattened.

There was a fair amount of dispersion in US high yield industry returns as the energy (driven by the rally in crude oil) and utility sectors outperformed, while telecom (driven by names like Frontier Communications on weak earnings; Sprint after merger talks with T-Mobile were called off), healthcare (Community Health on weak earnings) and retail (JC Penney) sectors were weak.

Corporate credit manager returns had a negative bias in November given the market backdrop, with mixed performance of reorganization equities, credit longs/shorts and stub trades. Puerto Rico muni debt saw further markdowns in November along with the debt of monoline insurers as investors continue to evaluate the full extent of the economic impact from the hurricane. Structured credit managers outperformed in the month as spreads grinded tighter across most securitized products sectors.