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Oktober 16, 2019
AIP Hedge Fund Solutions Team Review and Outlook
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AIP Hedge Fund Solutions Team Review and Outlook

AIP Hedge Fund Solutions Team Review and Outlook

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Oktober 16, 2019

 
 

As the third quarter unfolded it was hard to ignore the magnitude and velocity of changes taking place for traditional assets. Investors navigated an early-quarter risk rally fueled by a preemptive U.S. rate hike that was later offset by escalating U.S./China trade tensions. Fears of a U.S. slowdown mounted and global markets sold off in mid-August, with yields on the U.S. Treasury 10-year bonds falling to 1.5% by month-end.1 The year-to-date results of a traditional 60 /40 (S&P 500 and UST 10Y) portfolio surged in August, approaching post-crisis highs, and finished the quarter by rewarding a high level of dependency on negative stock/bond correlation and passive beta exposure. (Display 1)

 
 
 
Display 1: Strong YTD Performance Across US Equities and Rates
insight-aiphfteamquarterlyreviewandoutlook-DIsplay_1_v1
 

Source: Bloomberg, Morgan Stanley Research (October 2019)

 
 

However, during a two-week period in September one of the most violent growth/value factor rotations on record took place beneath the market’s surface,2 affecting many equity-oriented hedge funds. And later in the month, borrowing through repurchase agreements (“repo”) signaled funding stress. Rates surged to 10% as general collateral supporting those loans cheapened versus borrowing costs of overnight index swaps, raising concerns for leveraged strategies.3

Throughout the turmoil of the third quarter, the HFRI Fund Weighted Hedge Fund Index declined 49 basis points. (Display 2) Gains generated by macro and relative value managers could not offset the negative impact from the equity-oriented and high yield strategies. Nevertheless, overall hedge fund results remained strong for the year-to-date period, returning +6.7%. All strategies contributed to performance, and many helped to mitigate risk even as volatility continued to pick up in the equity, fixed income and commodities markets.

 
 
 
Display 2: Q3 and YTD 2019 Returns of Hedge Fund Indices
insight-aiphfteamquarterlyreviewandoutlook-DIsplay_2_v1
 

Source: www.hedgefundresearch.com as of September 30, 2019

 
 

On the positive side, macro managers returned +2.5% amid the August turbulence, capitalizing on the duration rally, front-end curve exposures and long U.S. dollar trades. (Display 3) Systematic and discretionary macro managers demonstrated low equity correlations, benefiting from meaningful rises in realized and implied volatility in equity and fixed income and to a lesser degree spikes in crude oil.  If the trajectory of global correlations continues to rise—they jumped in August—we believe managers employing more convex or more nuanced and tailored trade expressions may be more likely to outperform those using basic delta-one, or linear, approaches. Only the surprise outcome of Argentina’s August 11th primary election, whereupon all of the country’s equity, sovereign credit and currencies plunged, detracted meaningfully from returns of emerging markets-focused managers, who had enjoyed strong performance going into the summer.

 
 
 
Display 3: Q3 2019 Monthly Returns of Hedge Fund Indices
insight-aiphfteamquarterlyreviewandoutlook-DIsplay_3_v1
 

Source: www.hedgefundresearch.com as of September 30, 2019

 
 

In general, equity long-short managers were the laggards in the third quarter.  An acute growth/value and momentum style factor rotation in August and extreme movements in the U.S. during the second week of September caused one of the worst months for alpha production since 2010, according to Morgan Stanley Prime Brokerage4. (Display 4) Dissimilar to other factor unwind periods in which managers’ longs were particularly hard hit, in this de-risking episode, short positions did little to offset those losses. Furthermore, larger managers tended to have higher exposures to the more crowded names than smaller managers did, but managers unilaterally decreased gross and net exposure levels during the second half of September.

 
 
 
Display 4: Factor Performance
insight-aiphfteamquarterlyreviewandoutlook-DIsplay_4_v1
 

Source: language beneath the chart with the following: Goldman Sachs Portfolio Strategy Research US Macroscope: Five Questions and Answers on the Momentum Reversal 11 September 2019

 
 

Unlike prior sell-offs, this decline was orderly.  Managers actively sold longs while adding shorts, rotating out of healthcare, biotech and software and covering energy, materials, autos and retail.  As a whole, quantitative, multi-manager platforms and low net, high gross long/short managers worked out of their September deficits to finish the month modestly negative. On the other hand, many stock-picking generalists, who are less factor-aware and tend to rely on equity beta, posted surprisingly negative results during a month in which equity markets ended generally up.    

Conclusion

Today’s environment appears fragile, with heavy volatility selling, yield chasing and risk-embracing behavior affecting 3Q performance.  We foresee volatility increasing as episodes of geopolitical friction, monetary policy errors and liquidity holes start to coincide with economic and late-cycle fundamentals.  While the strong risk markets have been punctuated by brief sell-offs, the level of comfort and performance afforded by a 60/40 portfolio appears less certain today. As investors begin to focus on risk mitigation and sources of non-correlated return, we believe hedge fund solutions can serve as a valuable component of a well-constructed portfolio. 

 
christopher.morser
 
Managing Director
 
 
 
 

1 Goldman Sachs Portfolio Strategy Research US Macroscope: Five Questions and Answers on the Momentum Reversal 11 September 2019

2 Goldman Sachs Portfolio Strategy Research US Macroscope: Five Questions and Answers on the Momentum Reversal 11 September 2019

3 Morgan Stanley Prime Brokerage – Strategic Content Group September 2019 Hedge Fund Recap, October 3, 2019

4 Morgan Stanley Prime Brokerage – Strategic Content Group September 2019 Hedge Fund Recap, October 3, 2019

 

Index Descriptions

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.

NYMEX (New York Mercantile Exchange) Heating Oil futures index.

West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing.

 

IMPORTANT INFORMATION

The views expressed herein are solely those of the AIP Hedge Fund Team (the “Investment Team”) and are subject to change at any time due to changes in market and economic conditions. The views and opinions expressed herein are based on matters as they exist as of the date of preparation of this piece and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof. The data used has been obtained from sources generally believed to be reliable. No representation or warranty is made as to its accuracy, completeness, fairness or suitability.

Information regarding expected market returns and market outlooks is based on the research, analysis, and opinions of solely the Investment Team. These views do not represent views of other investment teams at Morgan Stanley Investment Management or those of Morgan Stanley as a whole. These conclusions are speculative in nature, may not come to pass, and are not intended to predict the future of any specific investment.

Certain information contained herein constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue” or “believe” or the negatives thereof or other variations thereon or other comparable terminology. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. No representation or warranty is made as to future performance or such forward-looking statements.

Past performance is not indicative of nor does it guarantee comparable future results.

This piece is a general communication, which is not impartial, and has been prepared solely for informational purposes and is not a recommendation, offer, or a solicitation of an offer, to buy or sell any security or instrument or to participate in or adopt any trading or other investment strategy. This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

Persons considering an alternative investment should refer to the specific fund’s offering documentation, which will fully describe the specific risks and considerations associated with a specific alternative investment.

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Alternative investments are speculative and include a high degree of risk. Investors could lose all, or a substantial amount of, their investment. Alternative investments are suitable only for long-term investors willing to forgo liquidity and put capital at risk for an indefinite period of time.

Alternative investments are typically highly illiquid—there is no secondary market for private funds, and there may be restrictions on redemptions or the assignment or other transfer of investments in private funds. Alternative investments often engage in leverage and other speculative practices that may increase volatility and risk of loss. Alternative investments typically have higher fees and expenses than other investment vehicles, and such fees and expenses will lower returns achieved by investors.

Funds of funds often have a higher fee structure than single manager funds as a result of the additional layer of fees. Alternative investment funds are often unregulated and are not subject to the same regulatory requirements as mutual funds, and are not required to provide periodic pricing or valuation information to investors. The investment strategies described in the preceding pages may not be suitable for your specific circumstances; accordingly, you should consult your own tax, legal or other advisors, at both the outset of any transaction and on an ongoing basis, to determine such suitability.

Morgan Stanley does not render tax advice on tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used with any taxpayer, for the purpose of avoiding penalties which may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and constantly changing. Clients should always consult with a legal or tax advisor for information concerning their individual situation.

The information contained herein is proprietary and protected under copyright and other applicable laws, and may not be reproduced or distributed. This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

Index data is provided for illustrative purposes only. Indices do not include any expenses, fees or sales charges, which would lower performance. Indices are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

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