Fundamental Commodity and Stat Arb Strategies Preferred for 2014 by FRM

From FRM Investment Management

Hedge funds had a small positive month to end 2013. The HFRX Global Hedge Fund Index recorded a 56bps gain, taking performance for the year to positive 6.72%. Within this there was some significant dispersion in manager returns, even within strategies, as the month contained some sizeable asset price movements.

Equity Long-Short was again one of the strongest performing strategies, with managers across all three main regions (Europe, Japan and the US) recording positive months. In Europe, markets sold off into the FOMC meeting, then rallied hard following the announcement. It was noticeable however, that even through the first two weeks, when markets were negative, managers were able to generate profits. During this period, the stocks that declined most in value were ones that investors considered to be overvalued. Although there was some profit taking, it was largely sensible and contained, rather than a rushed exit. Those that suffered in this period tended to be managers heavily reliant on a momentum based trading strategy; it was the stocks and sectors that had recently had a strong run that reversed. Following the announcement, there was a fairly indiscriminate rally, with returns in the second half of the month more attributable to beta. Most managers in the region are now looking to the upcoming quarterly earnings as the key event, which we see as a significant opportunity for managers.

Having had very little performance dispersion in October and November, Managed Futures performance was far more mixed in December, in aggregate finishing the month with a small positive. Once again the largest contributor was exposure to developed market equities. Given the selloff in the first two weeks, managers with a faster trading speed cut the equity position and did not benefit to the same extent from the rally in the second half of the month. A number of managers also made the decision to cut risk across the portfolio in the later stages of the month, fearing the lower liquidity that is associated with the festive period. Those that took this decision also lost out, not having the same degree of exposure to the rally. Aside from equities, currency trading was the largest positive for managers, with many maintaining their positioning in the Japanese Yen. Interest trading was the largest negative, with long positions losing money as a result of the Federal Reserve’s tapering decision. Although most managers were long bonds, the magnitude of this exposure is still very low in a historical context. We believe that the environment is continuing to improve (steeper yield curve, lower correlations, less chance of a shock to the rates market), but are still uncomfortable with the large positions in equity indices, and the crowding of some positions in developed markets.

Discretionary Macro managers were roughly flat in December, with risk usage in portfolios still relatively contained. One trade that continued to work well was the Japanese reflation trade (as it did in November) with managers again benefitting from Nikkei and Japanese Yen positioning, and to a lesser extent from JGBs also. Not many managers looked to actively trade around the tapering decision, as very few felt they had a genuine edge in predicting the Federal Reserve’s decision and implications. Given that this style of manager is often used to provide defensive support to a portfolio, current positioning (most are still content to hold developed equity positions) – as well as the fact that rising yields are likely to be the cause of risk asset problems – means we are less positive regarding these managers.

Despite the move in US treasury yields, Credit Managers ended December with a small positive return in aggregate, as the majority of managers hedge this exposure. In truth December was a rather uninteresting month for the markets. Looking forward there remains dispersion in credit markets, and several interesting opportunities for managers to generate returns (floating rate vs. fixed rate remains a theme). We still maintain our view that long exposure to credit does not have an attractive pay-off profile, and are instead more confident about the ability of those managers focussing on idiosyncratic opportunities to generate returns.

Early indications are that Statistical Arbitrage managers had a positive end to the year, with returns seemingly generated across a variety of factors and models. The stock dispersion that benefitted Equity Long-Short managers would have assisted, as would the observation from several managers that it was fundamentally overvalued stocks falling in value that caused the index pullbacks in the first few weeks of the month. The strong forward guidance on front end rates from the Federal Reserve is a positive going forward; with far less likelihood of a real shock in the rates market in the near future (in any case, given positioning changes it is unlikely that this would cause as large an impact on performance as we have had previously). We believe that this strategy will continue to do well as we move through the first part of 2014.

For what is usually a quiet period, corporate activity was strong in December, but was still short of the 200bn USD mark (195bn USD according to Bloomberg). Event Driven managers were positive over the month, with several of the most popular deal spreads tightening. Although activity in 2013 was healthy, it was not a huge increase from recent years, particularly considering the alignment of environmental factors. Confidence is the one input still missing from this equation, as it has been for some time. As always, the New Year has been welcomed in by some predicting a large pick-up in activity; we will continue to watch how the opportunity unfolds.

Metals managers were the strongest performing commodity strategy, with the majority correctly positioned in base metals (via both long front-short back end spreads and outright longs), and some also capturing the negative moves in precious metals. Commodity managers continue to offer a return stream that is uncorrelated to other asset classes, and to one another. We maintain our view that with a focus on the managers with a real fundamental edge, this is a useful addition to a portfolio.