The HFRI Fund Weighted Composite Index returned 5.9% in the first quarter of 2019, with all subindices reporting strong gains. It was the strongest start to a new year for hedge funds since 2006 and the fifth best quarter on record since 1990.1
Strong equity markets and solid alpha generation on the long side helped fuel the impressive 7.9% quarterly return from the HFRI Equity Hedge (Total) Index. The HFRI Event-Driven (Total) Index, up 4.2% in the quarter, benefited from equity beta exposure as well as rapid spread compression across the quality spectrum, especially in the BB, B, and CCC segments of the market. For Macro managers, being positioned long risk assets and short the U.S. dollar helped in January. However, as the U.S. yield curve flattened, and ultimately inverted at the 3-month /10-year point during the quarter, losses from short dollar positions and curve steepeners reduced quarterly gains. Overall, we believe it was a very successful quarter for hedge funds across all strategies (Display 1).
The shifting stance of global central banks had a significant impact on risk assets, interest rates and volatility. Post-Federal Open Market Committee meeting comments announcing the eventual conclusion of the U.S. Federal Reserve’s balance sheet reduction program dampened expectations about future U.S. rate increases (Display 2). This combined with the European Central Bank’s major policy reversal and the Bank of Japan’s accommodative stance signaled further monetary support; it caused the U.S. yield curve to flatten between 2-year and 10-year maturities, the crowded U.S. dollar (“USD”) trade to unwind and risk assets to rally (Display 3).
As of March 28, 2019
While volatility levels declined, many hedge fund managers updated their views and repositioned their portfolios accordingly: broadly speaking, Equity Long/Short and Event-Driven managers were the primary beneficiaries of these swings, whereas Macro managers profited to a lesser degree.
Equity Long/Short strategies were the standout performers in Q1, offsetting Q4 2018 losses. Moreover January performance proved to be one of the best months for these managers on record since the Global Financial Crisis. Generally speaking, Equity Long/Short managers generated positive alpha for two reasons: 1) successful maneuvering of style factors, particularly selling Value to buy Growth, and 2) sector rotation, benefiting from gains in Industrials, Energy and Technology-Media-Telecommunications. In addition, managers generally participated in the Q1 beta rally, where early-year high net exposure levels steadily decreased until late March. Most importantly, in February alpha recovered from its mid-2018 drawdown3.
Event Driven Credit strategies advanced on constructive supply/demand dynamics, a strong equity market recovery and continued access to credit markets. The lower likelihood of recession, supported by the U.S. Federal Reserve’s pause and adoption of a data-dependent approach, eased investors’ concerns about rising default risks and fueled gains. At quarter-end, the option-adjusted spread of the Bank of America Merrill Lynch High Yield Master II Index compressed 135 bps to finish at 398 bps from December 2018’s close and ended yielding 6.26%.4 In mergers and acquisitions, the roughly $775 billion5 of YTD deal volume represents a surprisingly low number of outstanding merger arbitrage deals. Many larger transactions closed at the end of 2018, reducing overall supply, and there were no notable deal breaks in Q1. As a consequence, deal spreads have tightened, causing Merger Arbitrage strategies to post solid results and contributing to overall gains for the Event Driven sector.
Positive quarterly results for discretionary global macro managers were mostly driven by short exposure to the USD early in the quarter and long exposure to risk assets throughout the quarter, which included the following: developed and emerging market (“EM”) equities; U.S., European and Brazilian interest rates; gold, and oil. Long-term technical CTA managers held back the broader Macro group. However, the majority of January losses were recovered thanks to the positive impact of long rate positions and reversing equity exposure from short to long as the quarter progressed.
We believe a balanced approach across strategies remains appropriate. In Equity Long/Short, we favor low net equity-exposure managers with sector expertise who focus on alpha, and we prefer opportunities in Europe and EM rather than the U.S. We believe that Relative Value strategies, especially in credit and structured product, provide ballast and that Mortgage Arbitrage may offer stable, albeit capped, risk-adjusted return potential. We continue to favor non-agency residential mortgage backed securities and the alpha opportunities available in the commercial mortgage backed securities space.
In Event Driven, we are most constructive on Merger Arbitrage strategies. While deal spread levels are temporarily suppressed because of tight supply, we expect the conditions for M&A activity to improve in the second half of 2019. We are the least constructive on Distressed, where tight spreads and low default levels limit opportunity. However, the extended longevity of the global growth cycle pushes a foreseeable slowdown further out, leaving pockets of opportunity in energy, Europe and EM.
Global Macro remains an area with unique risk/return properties and one where dislocations caused by episodic geopolitical events, such as U.S. / China trade tensions and Brexit fallout, can be quickly monetized.
Finally, we continue to find attractive idiosyncratic co-investment opportunities.
1 www.hedgefundresearch.com as of March 31, 2019
2 Curve represents the difference between the yield on the 2-year U.S. Treasury note and the 10-year U.S. Treasury note.
3 Morgan Stanley Prime Brokerage Strategic Content Group: February 2019 Hedge Fund Recap, March 7, 2019
4 Source: Bloomberg as of March 31, 2019
5 Global M&A volume, Thomson Reuters as of April 1, 2019
While the HFRI Indices are frequently used, they have limitations (some of which are typical of other widely used indices). These limitations include survivorship bias (the returns of the indices may not be representative of all the hedge funds in the universe because of the tendency of lower performing funds to leave the index); heterogeneity (not all hedge funds are alike or comparable to one another and the index may not accurately reflect the performance of a described style); and limited data (many hedge funds do not report to indices, and the index may omit funds, the inclusion of which might significantly affect the performance shown. The HFRI Indices are based on information self-reported by hedge fund managers that decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, L.L.C. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indices may not be complete or accurate representations of the hedge fund universe, and may be biased in several ways.
Hedge Fund Research, Inc. (HFRI) Fund Weighted Composite Index: The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to HFR Database. Constituent funds report monthly net of all fees performance in US Dollar and have a minimum of $50 Million under management or a twelve (12) month track record.
Hedge Fund Research, Inc. (HFRI) Macro Index. The HFRI Macro Index consists of investment managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short-term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and Equity Hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposed to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios.
Hedge Fund Research, Inc. (HFRI) Equity Hedge Index (long/short equity). The HFRI Equity Hedge Index consists of managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure and leverage employed.
Hedge Fund Research, Inc. (HFRI) Event Driven Index. The HFRI Event Driven Index consists of investment managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.
Hedge Fund Research, Inc. (HFRI) Relative Value Index. The HFRI Relative Value Index consists of investment managers who maintain positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types.