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MARKETS
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 annualised
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 annualised 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 (annualised
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 behaviour rather than fundamental information).
Issue Date: 1 June 2017
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 characterise 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-capitalisation 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 materialise, 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.
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HEDGE FUNDS
May was, broadly speaking, 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.
Issue Date: 1 June 2017
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-reorganisation Equities
that were generally weak over the prior few months stabilised 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 MortgageBacked Security (RMBS) and Collateralised Loan Obligation (CLO)
paper. Spreads were also firm across most other securitised products
sectors. Convertible valuations also improved in May driven by
underlying stock performance, tighter spreads and a modest intramonth increase in realised 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 behaviour during the month was
indicative of a large investor liquidating their quantitative portfolio, but
we don’t have direct evidence of this.
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CONTACTS
London
Tel +44 (0) 20 7144 1000
Fax +44 (0) 20 7144 2001
Switzerland
Tel +41 (0) 55 417 60 00
Fax +41 (0) 55 417 60 01
Liechtenstein
Tel +423 375 1045
Fax +423 375 1055
Tokyo
Tel +81 (0)3 6441 2460
Fax +81 (0)3 6441 2462
Sydney
Tel +61 2 8259 9999
Fax +61 2 9252 4453
Hong Kong
Tel +852 2521 2933
Fax +852 2521 8480
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