Man FRM Early View

March 2016

Originally published in the March 2016 issue

With the S&P 500 back to where it started the year, you might ask: what's changed? The answer is that sometime, probably in the last six months, the balance of opinion about the policies of the big central banks shifted from positive to negative. There are those who have been negative about QE and zero rates all along, of course, but they were outweighed by those who saw the necessity to offset the contractionary deleveraging of the banks and the consumer.
Now, however, those who doubt that the benefits outweigh the huge risks of what can be achieved through radical monetary policy measures are in the majority. The sheer uncertainty (attributable to both vacillation and the lack of transparency) around the actions of the Bank of Japan, the European Central Bank and the Federal Reserve since December has played a key role in undermining confidence. It is legitimate to ask whether the huge risks incurred by these policies can be justified, given the evident uncertainty of their authors.

The Fed is a particularly interesting case and very much of the moment with a spectacularly chaotic U-turn on rates guidance. In the past few weeks, we have heard a number of FOMC members take the opportunity of the recent equity market recovery and a sharp rise in inflation expectations (as priced by the market in break-even inflation rates) to press the case for an earlier tightening. In the meantime, Fed Chair Janet Yellen made surprisingly dovish remarks at the March FOMC press conference. Then at month-end, Yellen embarked on a somewhat mysterious speech at the Economic Club of New York, where she argued that ‘caution in hiking rates is especially warranted’ with ‘the economy inevitably buffeted by shocks that cannot be foreseen’. Wall Street has clearly taken this as a sharply dovish development.

Now you could say, confusion apart, this is just the Fed dropping into line with a market that never went anywhere close to believing the dot plot of forecast rate increases. Yet, the drop in US yields at the long end this year is a touch under 50 basis points – around the same as the core European markets, where equities are still materially down on the year notwithstanding Draghi firing his big bazooka. And then there is the currency. The USD started the year in robust form, but in March had its worst month in five years; it is now down 5% on the year against the EUR, 6.5% against the JPY, 9% against the RBL and 10% against the BRL.

Part of the point here is that investors have now been savagely whipped by each of the big three central banks in turn. The ECB started things off in early December (failing to expand accommodative policy) which led to the EUR rallying 3% in a roughly 5 standard deviation daily move. Next it was the BoJ’s turn: a rates move designed to weaken the JPY turned out to have exactly the opposite effect. The knock-on effect was to thump the Tokyo equity market so hard that it is still struggling to recover. And, then in March, came the Fed.

The broader impact of all this on global equities has been apparent in the savage sector and style rotation, as well as in the whip sawing effect unleashed in the main market indices. Confronted with this difficult background, a few of the best known hedge fund managers have violated a number of the most basic principles of money management and made some of the most dramatic errors of judgement since 2008.
It is striking, in this difficult period, just how comprehensively computers have outperformed people. They certainly don’t try to understand what goes through the mind of a central banker – which must help. Discretionary investment managers, by contrast, look a bit like those poor mice used in scientific experiments that are induced to play a game which they don’t understand, getting a reward if they win and electric shocks if they don’t. Just now there are quite a few investment managers sitting in the corner staring at the rewards, but refusing to play. In consequence, investment positioning is now light: CTAs have taken back a lot of their exposures from earlier in the year (leaving them a useful gain), and discretionary managers who were mostly too slow to cut risk in the first six weeks are now shy of buying it back.

Superficially, and in the short term, what the central banks have been doing is supportive of prices. However, we believe the consequences of this may well be leading to a widening of the gap between current pricing and the bigger cyclical and secular fundamentals. Computers will probably find this divergence easier to manage than people, while this prevails. Indeed, it could last for some time. The good news is that we may be in the process of being offered a second chance to possibly set up meaningful short positions.

Hedge Funds
Global financial markets continued to rise in March as most risk asset classes built on the price rally seen in the second-half of February. This helped the HFRX Global Hedge Fund Index increase 1.27% (March 30), leaving it down -1.85% for the first quarter of 2016. The March rebound drew on a recovery in risk appetite backed by the European Central Bank loosening policy further, while the US Federal Reserve Chair Janet Yellen adopted a dovish tone on rate increases.
The performance of the four main HFRX strategy bucketswas mixed. Performance gains for the HFRX Equity Hedge Index were fueled by rises in small-cap Financial, Technology and Emerging Asian equities. The HFRX Event Driven Index rose in February as high yield credit recovered and deal spreads tightened. In contrast, the HFRX Macro/CTA Index recorded negative performance, hurt by USD weakness. The following comments on hedge fund strategies are based on provisional data and analysis which may be revised as new information becomes available.

A number of Macro strategies struggled during March as fixed income prices exhibited volatility following ECB President Draghi’s decision to cut rates further into negative territory and extend QE. This saw European rates sell off, hurting managers with long Eurozone rates positions. Against this backdrop, Relative Value strategies generally outperformed, with several strategies increasing their risk allocation to cash-futures basis trading and Japan volatility trades. The USD bias also hurt Macro strategies given the weakness in the dollar and the fact that many managers were short commodity currencies like the CAD/AUD as well as the EUR and some Asian currencies. In Emerging Markets, Brazilian stocks rebounded 20% and the BRL about 10% on rising expectations that President Dilma Rouseff will be impeached. Some Emerging Market Macro strategies were hurt by this, but long-biased ones benefited from the tailwind.

The equities rally that started in mid-February continued during March, pushing US equity markets back into the black for the year. Unfortunately, this has not translated into positive returns for many US Equity Long-Short (ELS) managers. Cyclical sectors such as Energy and Materials have led the rally, but few managers have exposure or are short in these areas. Sectors which make up around 50% of hedge fund portfolios – Consumer Discretionary, Financials and Health Care have underperformed the S&P 500 and exacerbated the problem. In addition to the positioning headwind, the Value/Growth reversal continued in March, which hurt managers who had not made portfolio adjustments. Additionally, several specific stock events hurt managers, notably the large fall in Valeant shares.

In Europe, ELS managers continued to chalk up negative performance in March. The deleveraging activity observed in February continued through the first 10 days of the month, leading to further alpha losses from managers running Market Neutral strategies. From then on, equity markets resumed their rally following the ECB’s renewed accommodation and the Fed’s continued dovish sentiment. More importantly for hedge fund managers, the momentum reversal panic that caused the losses to date in 2016 looked to be subsiding during the second half of the month. Daily and weekly returns suggested that performance turned positive at month-end. In addition, following the substantial risk reduction seen in recent weeks, there is some indication now that managers are redeploying risk in response to the decline in market volatility. However, managers remain cautious of further volatility breaking out, making it unlikely that we will see the elevated levels of gross exposure that prevailed during 2015.

The start of the month marked a continuation of many of the themes observed in February for Statistical Arbitrage managers. Fundamental factor models continued their volatile movements, with price momentum once again suffering across regions, while value metrics continued their recent recovery. These movements dissipated in the second half of the month, and despite a difficult start, many fundamental managers will have ended close to flat. The early indications are that technical managers had a positive month amid declining volatility in equities. As price momentum sold off, many reversion strategies worked well.

Managed Futures faced challenges as longs in Fixed Income, which had performed well in early 2016, hurt many strategies due to the sell-off in bonds. Short commodities positions in crude oil and grains also generated negative performance, but precious metals recouped some of the losses as longs in gold and silver were positive. In FX, the main detractor was short EUR-USD, although many programs cut exposure to this trade as the month wore on.
Event Driven gained ground in March, even though Merger Arbitrage specialists lagged other strategies. Across the strategies, performance dispersion was very pronounced, ranging from +4% to -11%. Pure Merger Arbitrage strategies managers were up, but managers active in Special Situations and Credit performed better. The largest detractors were generally managers with exposure to soft catalysts in the Pharmaceutical and Healthcare sectors. Merger spreads saw volatility driven by a number of factors, including regulatory concerns which caused significant widening in one deal, while in another a competitive bidding situation pushed a stock beyond its price target. Deal activity in March amounted to roughly $316bn (including $131bn of proposed deals). Among the deals were competing bids for Starwood from Anbang/Marriott ($15bn), Columbia Pipeline/TransCanada ($12bn), Valspar/Sherwin-Williams ($11bn) and IHS/Markit ($10bn).

Credit also drew impetus from the general improvement in risk appetite, support from central banks and the continued recovery in oil prices. US high yield (HY) was bid by healthy inflows, while leveraged loans also saw modest inflows. Some of the better performing US HY industries were Energy, Metals/Mining, Retail and Chemicals – in other words, the largest underperformers over the past six-to-nine months.
Given the risk-on environment, it was not surprising that US and European HY markets outperformed investment grade. Lower-rated credits, in part driven by names in the Energy and Metals/Mining sectors, outperformed higher-quality names, reversing the trend of recent months.

Credit Long-Short managers reported mixed performance. Short bias strategies and well-hedged portfolios performed poorly given the strong rally in corporate credit. Credit Value, however, benefitted from the rally. The Structured Credit markets generally seem to have lagged the rally among more liquid corporate credits. Performance gains from principal and interest income were checked by losses from corporate credit and equity hedges as well as from synthetic CMBX hedges.

Among the few bright spots, were managers with exposure to post-crisis, credit-sensitive, longer-duration assets which early returns suggest have outperformed the legacy RMBS and CMBS markets. In Convertible Arbitrage, returns were generally positive helped by the rally in the underlying convertible equities as well as the narrowing in credit spreads.