Surface Calm Hides Challenging Trading Conditions

April proves a difficult month for equity long/short and others

FRM EARLY VIEW

We are stuck fast. US market levels at the end of April were little changed from the beginning of the month. The S&P 500 traded around flat year-to-date returns, a level which it has now crossed on nine occasions during the year, and US treasury yields ended the month unchanged. The US 10-year yield has now spent three months trading in a 23bp range, the tightest over this length of time since 1978. This is consistent with the view that we have been expressing for some months: despite a continuation of the main news stories from March, and worsening geopolitical risk from Ukraine, the dominant factor for the market remains liquidity provided by the largest central banks. Economic data remains mixed and markets are trading in tight ranges.

This relative calm at the index level, however, belied the intra-month volatility that occurred at the sector and single stock level. For the second month in a row the inter-sector volatility caused significant difficulties for hedge fund managers focused on equities. We are somewhat concerned whether this is an indication of a regime shift in the equity market, or whether the position clearance that clearly contributed to losses last month is still the driving force.

The background news stories of most importance have barely changed over the month. Ukraine continues to present significant tail risk. Markets currently remain sanguine about the situation and are clearly assigning a low probability of tensions having a major impact on financial assets. So far this has been correct with only minimal impact on emerging European assets.

In China the theme of reform continued to develop as the Hong Kong and Shanghai stock exchanges announced they were establishing a pilot programme allowing mutual stock market access between mainland China and Hong Kong. There remain a number of questions on the mechanics of the scheme, which will begin in six months, but this is another data point that supports the notion of a controlled liberalisation of the economy. The debate over economic growth also continued, with March trade data well below market expectations. Overall the consensus, as is always the case with China, seems to be that the authorities will be able to control the situation.

The third and most important market focus that we discussed was the Federal Reserve and the treasury yield curve. Janet Yellen made headlines again in April with a speech to the Economic Club of New York. This appeared to soften the “six-month” comment from the March FOMC Q&A session and placed greater emphasis on fundamental data, in particular the labour market. This had little immediate impact on the yield curve, as treasuries had rallied over the preceding two weeks while stocks were falling in value. The following day, however, there were strong fundamental data points: initial jobless claims were lower than expected, and the Philly Fed survey was the strongest for seven months. The result was a sell off at the front end, leaving the curve unchanged over the month.

Peripheral European bonds had another strong month and are now trading at yields not seen since before the Eurozone crisis. The Italian 10-year ended the month at 3.07 the Spanish 10-year at 3.02, and even the Greek 10-year fell to 6.16. The change in perception of Greece over four years is extraordinary. In 2010 the markets refused to refinance Greece’s debt when it had a public debt to GDP ratio of 125%. This month the country issued 5-year bonds in an auction that was seven times oversubscribed and yielded less than 5%. But Greece still has 25% unemployment, and its debt to GDP ratio has grown to 175%. Investors’ appetite for yield is dominating their perception of risk. What is also clear is that investors are putting their trust in the ability of the ECB to support orderly markets.

While equity indices ended the month roughly where they started, under the surface there continued to be a large shift in dynamics. The energy and utility sectors were two of the worst performing in 2013, but were the best performing strategies in April. The reverse is true of information technology, in particular new tech names, and biotech stocks. Growth factors significantly outperformed value factors. The result has been a pick-up in both cross sector volatility and the interquartile range of returns across sectors. Our rudimentary calculations show the last time both of these measures spiked together was in May and June 2013, suggesting the shifting interpretation of the Federal Reserve’s stance may be having more impact on market leadership than its muted effect on the yield curve.

The shifting dynamics have proved difficult for equity long/short hedge funds. If this is a result of anxiety about the Federal Reserve, it does raise the question of how the market would react should there be a real shift at the front end of the curve; all we have had is a reminder that in the future rates will go up. If on the other hand this is merely position clearance, there is a more immediate concern as data from prime brokers shows no reduction in gross exposure. Managers are generally unwilling to reduce gross exposure aggressively as they believe this is a technical not fundamental phenomenon, and do not want to miss the bounce that everyone expects. For now there is little to suggest that the instability has ended. The upcoming earnings season will likely give the market an opportunity to reevaluate fundamental valuations.
The year to date has been characterised by markets lacking direction, while shrugging off negative news stories and blaming poor fundamental data in the US on the inclement weather. The one constant contributor is cheap capital across regions driven by supportive central banks. Valuations, growth numbers and even the risk of sovereign defaults mean little when there is so much money in the system. For now it is impossible to predict when markets will break out of their range trading or identify a cause. The longer the range-bound trading continues, however, the stronger the reaction will be when the range breaks.

Market participants are closely watching the actions of the Federal Reserve, but it is well known now that they are on a path to reducing bond purchases which will remain set unless there is a significant setback in the recovery (annualised Q1 growth of 0.1% in the US was not enough), and will keep short-term rates at very low levels for the foreseeable future. Perhaps the answer to the question of breaking the range trading lies in Japan. The Bank of Japan’s (BoJ’s) huge stimulus programme is geared to achieve a 2% target for inflation. So far 2014 has seen little progress towards this, with the added complication that the increase in the sales tax could reduce consumption. Should the inflation rate undershoot the BoJ’s intended path the potential of further stimulus is large. If this causes the euro to strengthen further and inflation in Europe remains stubbornly low, this could finally force the ECB into abnormal monetary policy.

In summary, market indices are being supported by plentiful liquidity, but beneath the surface calm trading conditions are challenging.

Hedge funds
April was the second successivenegative month for hedge fund industry performance. The HFRX Global Hedge Fund Index returned -0.73%. In contrast to March, when losses were spread across almost all strategies (the exception being credit based strategies), losses in April were heavily concentrated in Equity Long-Short strategies.

The large rotation amongst sectors and from growth to value in the US continued in April. As in March, a number of managers were caught on completely the wrong side of the move and suffered large losses. A number were positioned correctly, however, and the result was large dispersion between manager returns. As we wrote above, one of our current concerns is the persistent gross exposure level. Managers believe that despite the market movements, the fundamental basis for many of their positions strengthened in April. Many have therefore kept gross exposure consistent with that view, and have hedged specific sector exposure using custom baskets. We have yet to hear a definitive explanation of what caused the shift in dynamics, and are therefore, absent any changes, large gross exposure could continue to be challenging.

In Europe there was a clear relationship between the performance of commonly held positions in the US and the subsequent day’s trading in European stocks. There were three separate periods of deleveraging in Europe; the 7-8th, the 11-14th and the 25-28th. Each of these periods followed a poor directional day for the NASDAQ index. Two features of these periods were particularly notable. Firstly, the size of the deleveraging was significant. On the 14th the performance differential between what we consider to be common hedge fund longs and shorts in the UK was 6%. Secondly, performance on these days was poor across managers that run very different strategies. The result was a bad month almost across the board for European equity long/short managers. Those who ended the month with stronger returns were managers who were able to generate strong performance in the interim days.

Despite two difficult months for equity long/short managers, many have only given back gains from the previous few months, and a sizeable minority remain in positive territory for the year. Equity long/short managers have generated very strong performance over the last year. The themes that have underperformed recently have been a large contributor to the prior strong performance. The majority of managers believe that the moves have been technical corrections, and continue to have confidence in the fundamental basis for their positions. The litmus test for this will be the upcoming European earnings season.

One of the most profitable strategies in April was A/H spread trading for relative value managers. The announcement of mutual stock market access between mainland China and Hong Kong was a positive development for the strategy, even if the mechanism remains uncertain. The managers that operate this strategy would like to add to the trade, but securing QFII capacity limits their ability to do so. The majority believe that in the six months leading up to the launch of the scheme prices will slowly converge.

Early indications are that statistical arbitrage managers ended the month with marginally positive returns. There was a clear reversal in performance mid-month. Large losses through the first two weeks were recouped by stronger performance in the second half of the month. This broadly matched the pattern of returns from equity long/short managers, but the continued sell-off in growth stocks had less impact on statistical arbitrage managers who typically have more diversified portfolios. A potential catalyst for the stronger performance in the second half of the month was the start of the US earnings season.
A number of managers use strategies that explicitly target earnings announcements. Value-based strategies continued to perform well over the entire month, while more momentum-based strategies stabilised late in the month after a difficult start.

Event driven managerperformance was muted in April. Special situations trading generally detracted from performance (in line with equity long/short managers) while traditional merger arbitrage contributed positively.

There are positive signs for the strategy on a forward-looking basis. Monthly deal activity was very high. The April total deal volume at $438 billion was the largest since June 2007; the pharmaceuticals industry in particular was very active. The nature of the activity was healthy, not just the volume. There are a large number of deals which are strong strategic acquisitions, have seen multiple competitive bids, and have regulatory complications. All of these situations should allow the expertise of event driven managers to add value.

Amid all of the technical issues that beset equity-based strategies, credit-based strategies were unaffected for the second month in a row. Strong technical factors continued to support spreads. Credit long/short managers performed well since the majority of managers currently have net long exposure, and the market was supportive to this positioning. In addition a number of idiosyncratic single security events worked in managers’ favour though the month. Although spreads are tight they are some way off historical lows and there is still ample evidence of investors reaching for yield.

Managed futures managers were flat in April. This was a substantial recovery from the mid-month drawdowns. Once again, the poor performance in the first half of the month was mainly attributable to the equity exposure. The best performing managers were lower frequency traders who did not cut their equity risk in the first two weeks. The best performing sector for the strategy was commodities. Managers have built sizeable net long exposure to both agricultural grains and natural gas, both of which were strong contributors to overall performance. Interest rate trading was a narrowly positive overall, mainly due to long positions in German Bunds, and some smaller positions in peripheral European sovereigns.

Discretionary macro manager performance continues to be dominated by the thematic exposure in Japan. This was a detractor from performance in April, and has not contributed meaningfully since the start of the year. Managers remain bullish on the region, but many now expect that reflation is likely to occur in the second half of the year. Interest rate exposure to G7 countries is now relatively more important for some managers, but there is less consensus positioning in comparison to Japan. The long equity positions that managers held at the beginning of the year have now been reduced and overall risk utilisation remains low.