Hedge funds hit by QE policies

Hedge fund managers are having a harder time to identify undervalued stocks due to QE policies, arges Hasan Aslan, portfolio manager Alternative Investments at RE YL & Cie.

In fundamental equity investing, company-specific, industry and economic factors are analyzed to determine the true current value of a stock. Every investor applies his own approach, with the investment philosophy varying by sector, geography and style perspective. On one hand, micro level considerations in the research process relate to company-specific factors, such as the evaluation of the business model, the analysis of balance sheet, income and cash flow statements, and the assessment of management. On the other hand, GDP growth, interest rates level, exchange rates, and commodity prices are amongst macro factors taken into account by investors. The importance attached to macro or micro factors can significantly differ between investors.

Hedge funds performing fundamental analysis build long positions in undervalued and short positions in overvalued companies. A higher net long exposure is an expression of increased confidence in the economic landscape, whereas the opposite represents a cautious positioning. In general, long/short managers hold a net long biasover time.

During the past years, unconventional monetary policies applied by major central banks around the globe have significantly distorted financial asset prices. The new conventional wisdom is that central banks have the ability to prevent their economy from slipping into deflation by creating new money and buying government bonds. Consequently, quantitative easing programs have induced strong inflows in risky assets, with investors piling into ETFs and mutual funds on the future promise of an asset purchase program. To illustrate this point, the bulk of the European market rally of the beginning of the year occurred before the ECB had started to deploy one single euro. Here, we set the discussion about the effectiveness of these policies apart but would rather focus on their impact on stock prices.

The adverse effect of these policies is that the stock price of companies with weak fundamentals could increase for a sustained period of time due to massive inflows from investors wanting to buy equity indices. On top of that, CTA funds, risk parity programs and other trading systems are jumping into the bandwagon after the formation of a trend, hence, amplifying the moves to the extreme. Inversely, during sell-off periods, these systems are rapidly exiting the same positions, snowballing the downward pressure.

Hedge fund managers have been facing a challenging time to deliver alpha in an environment where central long positions in undervalued and short positions in overvalued companies. A higher net long exposure is an expression of increased confidence in the economic landscape, whereas the opposite represents a cautious positioning. In general, long/short managers hold a net long biasover time.

During the past years, unconventional monetary policies applied by major central banks around the globe have significantly distorted financial asset prices. The new conventional wisdom is that central banks have the ability to prevent their economy from slipping into deflation by creating new money and buying government bonds. Consequently, quantitative easing programs have induced strong inflows in risky assets, with investors piling into ETFs and mutual funds on the future promise of an asset purchase program. To illustrate this point, the bulk of the European market rally of bank actions have become the key driver of asset prices, with stock picking being less relevant. Equity shorting can turn out to be a painful exercise, especially for funds using hard stop loss rules.

In response to this, managers have started to adjust their investment philosophy. Macro analysis takes now an increasingly noteworthy part in the research process. Economic, credit, and sentiment indicators are integrated in the investment process to manage exposure levels of the fund in the short-term, either through the use of equity index futures or by acting on the existing positions. These indicators are worthwhile to get an early warning system for both downside protection and upside capture. Managers are cognizant that these indicators will enable them to navigate current markets without being in an enforced risk management mode. Another element is the higher dependence of hedge fund exposures to central banks’ minutes and speeches. Generally, immediate action is taken to reduce or increase the overall risk level of the fund as stock selection becomes less relevant in the period to follow. This is in contrast with the past when managers were generally less inclined to act on the portfolio in the very short-term and had higher conviction in their positioning.

We are seeing an increasing number of fundamental equity shops relying on technical analysis, to predict security price movements based on charts and statistics generated by market activity. Managers are clearly admitting that the emotional component is more important in current markets. One of the key metrics integrated in the investment process is the analysis of ETFs and mutual funds flows to validate the inclusion of new ideas in the fund or direct the research towards markets with the largest flows in order to find investment opportunities.

Asset prices might experience extreme moves in the short-term due to central bank rhetoric, causing irreversible damage for fundamental stock pickers. Therefore, when selecting hedge funds, close attention needs to be paid to these elements to spot fundamental equity long/short managers capable of aligning their way of investing with the new environment.

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