AIP Hedge Fund Solutions Team Review and Outlook
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.
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 is made as to its accuracy or completeness.
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.
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 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.
NOT FDIC INSURED | OFFER NOT BANK GUARANTEED | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A BANK DEPOSIT
© 2019 Morgan Stanley Investment Management