2013: SEB sees better potential in hedge funds
Less politics means better prospects for hedge funds going forward, according to SEB’s latest review of the asset class.
The third quarter was dominated by increased activity on the political front. In July, markets were driven by the now familiar anxiety about peripheral euro zone countries. Risk assets fell and yields rose on assets in those countries. However, in late July European Central Bank (ECB) President Mario Draghi announced that the ECB would “do whatever it takes” to save the euro, followed by a pledge of unlimited bond purchases in crisis-afflicted euro zone countries that applied for financial support. These announcements immediately had a positive impact on market sentiment, setting the tone for the rest of the quarter. Overall, it was a positive quarter for hedge funds.
The HFRX Global Hedge Fund Index rose 1.45% while the MSCI World Equities Index rose 6.1% (in EUR). The HFRX Equity Hedge Index performed best in light of the strong equities market, followed by the HFRX Event Driven Index.
Strategies that did worse were Net Short Bias and Merger Arbitrage. However, there was considerable variation as always between fund managers. In Macro CTA, many of the biggest players posted negative or unchanged results, while the index rose about 1 per cent during the period. We will continue to focus on managers who are free to quickly rotate their portfolios and have less structural exposure and focus on markets. We are avoiding less liquid strategies although we realise there is good potential in Distressed and Structured Credit. We are reducing our CTA holdings but still see value in their diversified characteristics relative to other asset classes.
We divide the hedge fund market into four main strategies:
– Equity Long/Short
– Relative Value
– Event Driven and Distressed
– Macro and Trading
This strategy has had a difficult period, with the share price trend more or less de-coupled from companies’ fundamental values. Returns have thus been more closely linked to managers’ net exposure to the stock market rather than to their choice of equities, so managers with a high net exposure to equities have followed the market both up and down.
Equity Market Neutral has had the hardest time – this strategy has fallen over 5 per cent in 2012 (HFRX Equity Market Neutral Index in USD). Risks were generally reduced during the second quarter, while managers have been more temperate about taking on more risk during the current quarter.
We predict that the market will continue to be driven by political developments rather than company fundamentals. The best potential in the Equity Long/Short category is thus fleet-footed strategies like Trading and Variable Net Exposure, where exposures can quickly be adapted to swings in market sentiment.
Managers who can generate returns by going both long and short should fare better than those who are more dependent on the general direction of the market. Equity Market Neutral will most likely be resilient over the somewhat more uncertain period we see just ahead. If there is a stock market rally, the strategy will not perform particularly well, but overall it should contribute a positive return at a very low risk.
Fixed income strategies have had a difficult quarter, with growing credit spreads and high volatility for fixed income instruments that have longer maturities. Managers were, and are, general cautious about investing on the short end of the yield curve, where interest rates are low. The HFRX Relative Value index fell 1.6% (in USD) in May and has trended flat since then. Managers who tend to short the credit market generally did well in the second quarter, but the situation has reversed in the current quarter, with credit spreads narrowing.
Management styles focused on short-term yields will probably continue to have a difficult time ahead, so we prefer strategies focused on the medium to long end of the yield curve. After ECB president Mario Draghi’s announcement in late July, indicating that the ECB can begin buying government bonds issued by peripheral euro zone countries (Spain and Italy in particular), the yield gaps between northern and southern Europe have narrowed.
However, we have not yet seen any concrete steps, and the ECB’s actions going forward are likely to have a major impact on Relative Value strategies. On the other side of the Atlantic as well, a new dose of quantitative easing is being discussed, which also creates opportunities for the strategy – regardless of whether it is implemented or not. We are therefore positive towards Relative Value and especially managers focused on fixed income instruments.
Event Driven and Distressed
Event Driven strategies generally depend on corporate events such as restructurings, acquisitions and divestments. However, higher volatility and falling share prices in the second quarter led many companies to postpone such decisions, and the HFRX Event Driven Index lost 2.7% (in USD) during the
period, most of this in May.
Should the stock market continue to soften, it is possible that the number of corporate events will increase again. Low demand and slow growth generally mean that companies will try to grow through acquisitions to a greater extent, which favours Merger Arbitrage. Meanwhile, companies are finding it increasingly hard to get bank loans, leading them to focus on restructuring their balance sheets. Event Driven managers with exceptionally good expertise in credits and equities thus have the best potential.
Macro and Trading
Macro and Trading strategies have the best potential on paper given global tensions, but they have also been the biggest disappointments in recent months. Some managers have had a negative outlook on the euro since the turn of the year, and those positions finally paid off in the second quarter. Nonetheless, gains were basically generated by bond holdings. As we noted earlier, the market is largely driven by sentiment, which is in turn driven by decisions in the political arena. These decisions are difficult to factor into model-driven strategies, and this year CTA has lost over 3% (in USD), compared to Macro generally, which is down 0.3%.
We still believe that CTA and Systematic Macro belong in a portfolio as holdings that generate an absolute return and provide diversification. The CTA model today is generally more negative towards equities and commodities, so it includes positions in government bonds and US dollars. These strategies thus offer good diversification in a pro-cyclical portfolio.
However, we expect the market to swing back and forth, so models with a shorter time frame are preferable.