AIP Hedge Fund Solutions Team Review and Outlook
August 05, 2019
Hedge funds recorded their best first half since 2009, appreciating +1.9% in Q2 and posting +7.4% YTD.1 (Display 1) All strategies produced positive results during the volatile quarter, with Macro leading and Event-Driven lagging, even though equity markets dominated the headlines.
Macro was the big winner in Q2. Managers with long rate and curve steepener biases profited as fixed income investors once again braced for worldwide discovery of the lower limits of nominal rate policy. U.S. Treasury yields dropped towards the 2.0% level while 10-year German bund yields approached -0.40%. Divergence within Emerging Markets, both regionally and by asset type, explained much of the manager performance dispersion we saw within the space. In general, Latin America and Eastern Europe were strong, while Asia was weak. In foreign exchange, managers profited from long exposure to the Argentine peso, Brazilian real, Mexican peso, South African rand and Polish zloty. With increasing focus on Brexit, many managers are favoring short British pound exposure. Managers with adroit timing in the energy complexes made money during the quarter, as short positioning in West Texas Intermediate (“WTI”) (-16.3%) and NYMEX Heating Oil (-11.5%) paid off in May. CTA managers also added to success for the Macro category thanks to long global equity and rate allocations as well as short natural gas and industrial metals exposures; contributions from long gold and soft commodities also helped.
Strong equity long/short performance was driven by, and manager dispersion hinged on, the mix of total equity beta, sector focus and the dynamism of exposure management. Both gross and net exposures declined rapidly in May, as many managers de-risked into rising volatility. Once markets turned positive, the buy skew jumped because of short covering, with risk ramping up thereafter. Gross exposures expanded to the 175% - 200% level while net exposures hovered around the mid 40’s.1 Managers closed out the quarter with gross levels and momentum exposures higher. Interestingly, many managers rebuilt their books with a mixed bias toward growth / defensive positions. This theme is rooted in the tendency of growth companies to outperform in prolonged periods of muted expansion, while defensive sectors like healthcare tend to provide downside risk mitigation when markets sell off. The rapid adoption of this playbook is reawakening crowding risk, which was largely absent in the first half of the year.
The success of activist and event-driven equity managers in Q2 stemmed mostly from equity beta rather than any specific value realization events. However, tighter deal spreads throughout the quarter aided many risk arbitrageurs. Notable Q2 contributions came from First Data/Fiserv, Worldpay/Fidelity and Celgene / Bristol Myers as well as the closure of the Red Hat /IBM deal on June 27th. Credit investors stepped away from distressed investments in early Q2 in the face of mounting concerns over a slowing economy and deteriorating quality. High yield spreads widened, exceeding 450 basis points during May only to recover quickly as the clamor for yield and renewed confidence in the “Powell put” allayed concerns of any immediate defaults.
Thanks to improved performance and a modest reversal in the withdrawal trend, hedge fund industry AUM reached a record high of $3.25 trillion2 in Q2. Larger managers, those in excess of $5 billion, saw inflows, while smaller managers, especially those in the $1-$5 billion AUM range, experienced outflows. At the strategy-level, event-driven and relative value strategies attracted assets, while macro and equity long short continued to suffer redemptions. Overall, $4.9 billion exited the industry in Q2, as investors reassessed volatility going into the H2.
We find the opportunity set for hedge funds more compelling at this juncture than in previous risk-reversal episodes, and we believe that hedge funds offer an attractive risk-adjusted alternative to equity or fixed income investments. Equity prices are at or near record highs and, in our view, the potential for further appreciation seems limited. At the same time, over $12.5 trillion of all outstanding global sovereign debt is trading at negative yields.3 While markets recovered quickly after the May 2019 selloff, we expect unintended policy errors, slowing growth or disappointing earnings to increase volatility in the second half of the year. (Display 2) In our opinion, this will create an environment in which hedge fund managers are well-positioned to generate alpha.
Source: Bloomberg as of June 30, 2019
1 www.hedgefundresearch.com as of June 30, 2019
2 www.hedgefundresearch.com as of June 30, 2019
3 Morgan Stanley Prime Brokerage Hedge Fund Recap: June 2019 (July 8, 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.
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.
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