Victor de Oliveira, Portfolio Manager and Head of Investment Strategy, SEB Luxemburg
The strong start to the year came to an end in the second quarter. The fading effects of the European Central Bank’s Long Term Refinancing Operation (LTRO, three-year loans at 1 per cent interest) reduced risk appetite, while increasing volatility made the market difficult for fund managers to navigate during the second quarter. However, some hedge funds recovered in July and August. The HFRX Global Hedge Fund Index fell 1.9 per cent (in USD) during that period but has risen 0.9 per cent so far this quarter. The market is being driven mainly by investor risk appetite and sentiment, which in turn are driven by unpredictable political decisions. Central bank actions are also driving hedge fund returns to a growing extent, as are hopes for a new round of quantitative easing from the US Federal Reserve (the Fed) or the European Central Bank (ECB)’s potential purchases of government securities from peripheral euro zone countries. Depending on how much these prospects have been priced in, fund managers can benefit to varying degrees from such speculation. Yet regardless of whether fund managers are right or wrong in the positions they take, more fleet-footed managers and strategies will have better opportunities in the coming months.
As before, 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 rough period, with share prices more or less de-coupled from companies’ fundamental valuations. Return has instead been connected more to the fund manager’s net exposure to the equity market than the choice of equities, so managers with high net exposure to equities have followed the market both up and down. Equity Market Neutral had the hardest time – the strategy has fallen this year by more than 5 per cent (HFRX Equity Market Neutral Index in USD). Risks were brought down in the second quarter, while fund managers have been more restrained about taking on risk again in the current quarter.
We predict that the market will continue to be driven by political developments rather than company fundamentals. The strategies with the best potential in the Equity Long/Short category are fleet-footed ones such as Trading and Variable Net Exposure, where exposures can quickly be adjusted to shifts in market sentiment. Managers who can generate a return both by going long and going short should fare better than those
who are more dependent on the general direction of the market. Equity Market Neutral will probably be resilient in the slightly more uncertain period we foresee in the immediate future. In a stock market rally, it would not perform particularly well but on the whole should contribute to more positive returns with very low risk.
Interest-bearing strategies had a rough second quarter, with widening credit spreads and high volatility in interest-bearing instruments with longer maturities. Fund managers were and remain generally restrained with their investments at the short end of the yield curve, where yields are low. The HFRX Relative Value Index fell 1.6 per cent (in USD) in May and has trended flat since then. Managers who tend to be short in the credit market generally did well in the second quarter, but the opposite is true for the current quarter, when credit spreads
Management styles focused on short-term yields will probably continue to have difficulties for some time going forward. We instead prefer strategies that focus on the medium to long end of the yield curve. Since European Central Bank President Mario Draghi’s announcement in late July, which signalled that the ECB may begin purchasing government securities issued by peripheral euro zone countries (Spain and Italy in particular),
yield spreads between northern and southern Europe have shrunk. However, we have not seen any concrete action as yet, and the ECB’s actions going forward will probably have a major impact on Relative Value strategies. A new round of quantitative easing is also being discussed on the other side of the Atlantic, which also creates opportunity for the strategy – regardless of whether such moves are launched or not. We are therefore positive towards Relative Value and especially fund managers focused on interest-bearing instruments.
Event-Driven and Distressed
Event-Driven is generally dependent on corporate activities such as restructurings, acquisitions and divestitures. However, high volatility and falling share prices in the second quarter led many companies to postpone decisions, and the HFRX Event Driven Index lost 2.7 per cent (in USD) during the period, most
of this in May.
Should stock markets continue to soften, the number of corporate transactions may start to rise again. Weak demand and slow growth generally point toward companies trying to grow through acquisitions to a greater extent, which favours Merger Arbitrage. Meanwhile, companies are finding it increasingly difficult to borrow from banks and as a result are focusing on restructuring their balance sheets. Event-Driven fund managers with exceptional expertise in credits and equities thus have the best potential.
Macro and Trading
On paper, Macro and Trading strategies have the best potential given global tensions, but they have also been the greatest disappointments in recent months. Some fund managers have had a negative view on the euro since the turn of the year, and these positions finally paid off in the second quarter. However, profits were essentially generated by bond holdings. As we noted earlier, the market is being driven largely by sentiment, which in turn is driven by decisions in the political arena. It is difficult to factor these decisions into model-driven strategies,
and during the year CTA has lost over 3 per cent (in USD), compared to Macro in general, which is down 0.3 per cent.
We still believe that CTA and Systematic Macro belong in a portfolio as holdings that offer an absolute return and diversify risk. CTA models today are generally more negative towards equities and commodities and thus include holdings in government securities and US dollars. These strategies therefore offer good diversification in a pro-cyclical portfolio. However, we foresee the market swinging back and forth, so models with a
shorter time frame are preferable.