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February 11, 2020
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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February 11, 2020

 
 

In 2019, hedge funds, as measured by the HFRI Fund Weighted Composite Index, posted their best results in a decade. Every major strategy group delivered positive performance, and the HFRI Fund Weighted Composite Index rose 10.4% for the year. (Display 1)

 
 
 
Display 1: 4Q and 2019 Performance
aip-hedge-fund-solutions-team-review-and-outlook-1
 

Source: As of January 22, 2020, Hedge Fund Research, Inc. Past performance is not a guarantee of future results.

 
 

Propelled by strong equity markets, Equity Long/Short was the top-performing group in 2019, up 13.7% for the year. Managers turned the tide on alpha generation producing some of the strongest stock selection results since 2013.  (Display 2)  Sector-focused strategies such as Healthcare and Technology were particularly notable.

 
 
 
Display 2: Long Appreciation - Short Appreciation
aip-hedge-fund-solutions-team-review-and-outlook-2
 

Source: Bloomberg, Morgan Stanley Prime Brokerage, data as of December 31, 2019

 
 

Equity-oriented managers went into the close of the year with high levels of gross and net, signaling optimism and confidence about what lies ahead.

Mega deals and a surge in 4Q activity helped worldwide M&A levels reach $3.9 trillion in deals for the year1, exceeding 2018 levels. Topped by the $135 billion United Technologies/Raytheon deal, the $74 billion Bristol Myers/Celgene deal, and a flurry of announcements in November, the opportunity for stock pickers, activist and merger arbitrage managers expanded. Indeed, in the Event Driven space, activist strategies delivered the strongest performance—up 18.3%—thanks in part to the high profile AT&T campaign and Papa John’s boardroom contest.

While still positive for the year, the Distressed / Restructuring sector was held back by losses from exposure to the energy, telecom and retail sectors.  One of the more noteworthy events of 2019 was a major setback in Pacific Gas & Electric’s pre-packaged bankruptcy filing.  Regulators discovered faulty equipment was responsible, increasing claims and reversing profitable strategies.  While the lowest credit quality cohort underperformed and select managers experienced redemption pressure, we believe the opportunity set is fertile, assuming the improving environment continues to extend the duration of this late-stage credit cycle.

Relative Value strategies were further buoyed by interest rate stabilization and tighter spreads. Interest rate volatility levels declined and balance sheet intensive traders took advantage of supply/demand dynamics going into year end. While the evolving liquidity conditions and market technicals proved challenging in 3Q, ample liquidity injections caused yearend activity to be a non-event. As a result we believe short-term mean reversion strategies within the fixed income relative value space may see improved return opportunities as distortions in global yield curves are quickly corrected.

Even though Macro strategies were down in Q4, they were positive for the year, led by active trading. Currency-related strategies tended to be flat, where gains from long US dollar and Swiss franc exposures were offset by losses from short exposure to the Turkish lira or long exposure to the Chinese renminbi.  In general, systematic commodity trading advisors had a good year with strong performance coming from breakout models and long exposure to equities, interest rates and trending currencies.  Exposure to agricultures and the energy complex detracted, as did backwardization and contango models.

Industry Assets and Flows

Hedge funds had a very strong year and asset flows turned around in November, according to eVestment2. During the year, there were five new fund launches in excess of $1.0B; the top ten launches raised $10.4B. By year-end, total industry assets under management had reached $3.32 T3, a record high, and it was performance, not flows, that drove the overall increase. In terms of flows, Event Driven experienced the strongest uptake, but investor interest in Credit and Mortgage-Backed Securities strategies also became evident as the demand for yield increased. On the flip side, investors reduced exposure to underperforming and high cost Equity Long/Short and Macro strategies while trimming Relative Value and Market Neutral managers as concerns about rising volatility diminished.

Looking Ahead

From our perspective, moderating recessionary concerns have set the stage for 2020. Interest rates and volatility levels have moderated while markets have reached new highs. With a more supportive global economic backdrop and risk assets adjusting accordingly, our views on hedge fund strategies remain constructive. However, it is worth noting three developments: 1) We are more sanguine on alpha potential in the Equity Long/Short space; 2) we believe increases in stress and dispersion in high yield credit are attracting early-entry risk capital; and 3) we see opportunities in credit, given tight spreads are most pronounced in the asset-backed securities sectors.

Having a more constructive outlook also gives us confidence to pursue higher volatility managers, while preserving the benefits of low market correlation. We continue to concentrate holdings in top-tier managers and upgrade our trading roster, seeking to express active risk through the most cost-effective structures and with the most attractive capacity agreements. By combining higher return targets with low beta strategies and leveraging savvy implementation options, we are optimistic about the potential for hedge funds to deliver attractive risk-adjusted returns in 2020.

 
 

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.

 
 

1 https://fortune.com/2019/12/31/super-mega-mergers-deals-2019/  December 31, 2019

2 eVestment Hedge Fund Asset Flows Report, Nov 2019

3 HFR Global Industry Report – Year End 2019

 
christopher.morser
Managing Director
AIP Hedge Fund Team
 
 
 
 

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.

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