K2’s 2015 Outlook – Bias To Lower-Beta Sector Specialists In Equity Hedge

David C. Saunders, Founding Managing Director, & Robert Christian, Head of Research, K2 Advisors

 

K2 logoWe think earnings growth trends should provide support for long/short equity strategies in 2015, particularly in terms of specialty managers in areas such as health care, technology and activism. Meanwhile, opportunities in relative value have continued to evolve due in part to changing regulatory regimes. An upswing in mergers, spinoffs, recapitalizations and restructurings during 2014 should continue providing robust opportunities to event driven strategies, while we expect diverging global central bank policies to continue providing a fertile investment environment for global macro strategies.

 

While we think earnings growth should provide support for long short equity strategies in 2015, we see limited room for price-to-earnings ratio expansion. We see opportunity in Japan based on government policies and an increased focus on profitability. Growth in Europe has remained sluggish, but pockets of opportunity exist according to our analysis. Given the generally strong run in equity markets since early 2009, we expect there will likely be less of a beta, or general market, tailwind in 2015. We believe the strongest opportunities could come from specialty managers in areas such as health care, technology and activism based on our views on dispersion, demographics and product cycles, among other factors. Within some of these sectors, however, we may look to shift to managers with lower beta, or market risk, profiles.

Within corporate credit strategies, given historically tight credit spreads and expectations for rising interest rates as of December 2014, many managers have begun to focus increasingly on long/short and event driven situations to try to diversify their opportunity sets. While managers focused on distressed credit face a limited amount of restructuring activity, from our perspective the energy sector is an emerging area of opportunity. In structured credit, we expect more focus on alpha1 generation by managers as we believe market inefficiencies will continue to offer trading and relative value opportunities.

Opportunities in relative value have continued to evolve with the increased complexity in capital markets, prompted in part by the changing regulatory regimes in many countries. Managers in convertible arbitrage, volatility arbitrage and fixed income strategies have been playing an ever-greater role as marginal price setters and liquidity providers, with investment banks continuing to exit market-making and proprietary trading businesses. Resulting changes in market dynamics, while a source of opportunities, may also result in greater liquidity risk for both hedged and long-only investments in these same instrument classes.

For event driven strategies, corporate activity was on pace during 2014 to reach the highest level since 2007, providing a robust opportunity set. With global gross domestic product growth still anemic as of late-2014, companies have been trying to boost earnings growth by utilizing transformative corporate events, including mergers, spinoffs, recapitalizations and restructurings. Additionally, activists have continued to gain influence and seem likely to be a positive driver of future corporate activity.

For commodities strategies, we expect continued improvement in the market environment for discretionary managers. Correlations to other asset classes and correlations among commodity sub-sectors have decreased in 2014. We expect absolute price moves to increase due to adjustments in supply and a pickup in demand. This should increase volatility as well as opportunities for both long and short trades. From our perspective, agriculture and energy are the most favorable sub-sectors of the commodity markets, whereas we see a smaller opportunity set in base metals. Risks to this outlook include macro events that reverse the generally positive trend.

Finally, we expect diverging global central bank policies to continue providing a fertile investment environment for global macro strategies. While we think it is unlikely, a sooner-than-expected increase in US interest rates could potentially create volatility in emerging markets. We may consider adjusting exposure to global macro managers with a focus on emerging markets if global inflation exceeds investor expectations and central banks begin to take a less dovish stance.

 

About K2 Advisors

K2 Advisors provides integrated hedge fund product solutions covering multiple strategies to sophisticated institutional and high-net-worth investors worldwide. On November 1, 2012, K2 became part of Franklin Templeton Investments.

1. Alpha is a measure of value added by a manager. It is calculated as the difference between a manager’s performance and the manager’s expected performance (defined as a portfolio’s beta times the market return). A positive alpha indicates that a manager has performed better than its beta would predict. In contrast, negative alpha indicates the investment portfolio has underperformed, given the expectations set by beta.

 

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