AIP Hedge Fund Solutions Team Review and Outlook
October 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)
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.
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.
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.
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.
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.