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octubre 29, 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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octubre 29, 2020

 
 

Please see important disclosures at the end of this article.

Hedge funds rose 4.1% in Q3 on the back of a 9.1% gain in Q2, resulting in the strongest consecutive quarterly gains in over two decades1. All broad strategy groups were positive with Equity Hedge and Event Driven managers leading the way, bolstered by strong equity performance. Many Relative Value strategies benefited from tighter spreads and curve flattening dynamics. While positive, Global Macro, as represented by the HFRI Macro (Total) Index, was the laggard this quarter. There was a clear separation between performance of discretionary thematic, currency and commodity managers, which have performed very well, and the systematic, trend following strategies, which have struggled.

 
 
 
Display 1—Hedge Fund Industry Returns for the Quarter
Q3 2020
 

Source: Hedge Fund Research, Inc., as of October 15, 2020. Past performance is not a guarantee of future results.

 
 

Equity Long/Short was the standout in Q3. Results were driven by sector rotation, factor shifts, thematic adjustments and risk management. The Fed’s late August inflation target policy adjustment caused many managers to shift biases toward cyclical and reflation trends, accentuating growth/value dynamics and defensive/cyclical unwinds. A trend of selling into strength and shedding select technology and work-from-home stocks in order to buy companies and sectors expected to benefit from a broader economic re-opening became more pronounced. As we saw the number of COVID-19 outbreaks accelerate into September, managers shifted back to mega-cap growth names. Intense option buying and selling of high profile tech stocks created notable gamma lift in August and early September, a condition when hedged dealers are forced to buy stock regardless of its price. Considerable put/call activity, wagering on the outcome of the U.S election, is distorting short-dated skew pricing. However, many managers recognize uncertainty is not just specific to November 3rd. Forward volatility remains very elevated in November, December and well into Q1 2021.  As a result, index put buying remains low, gross leverage remains high (especially on the long side) and crowding is extreme.

Event driven credit and distressed managers saw high yield spreads tighten early in the quarter until September when the option adjusted spread of the BofA Merrill Lynch High Yield Master II Index widened 32 basis points to close at +532 bps. Even though low quality credits rallied this quarter, detracting on the short side, most managers maintained a long high quality/short low quality bias. While performance in general was solid, differentiation in returns among managers proved to be a function of pre-COVID-19 exposure to energy, retail and the California utility PG&E, plus the degree of concentration in gaming, hotels and hospitality investments.

Global M&A deals and volume closed Q3 on an upswing, adding $891 billion in deal value, resulting in an anemic $1.86 trillion year to date, the lowest level in decades and down 28% from Q1 - Q3 in 20192.  However, IPO activity was a bright spot, with 872 companies launching and raising $165.3 billion3.  Several managers benefitted from thoughtful participation in standout equity capital market holdings, including Snowflake (IPO), Ant Group (Largest IPO filing), Palantir (direct listing) and multiple SPAC listings. In general, many managers expect an M&A pickup in Q4, providing campaign and trading opportunities for Activist and Event Driven Equity strategies.

Macro Active Trading and Discretionary Thematic managers, as defined by related HFRI indices, were up 3.5% and 2.9% in Q3. Variations of 2s/10s and 5s/30s yield curve steepeners, USD weakness and directional equity and risk-on / risk-off positioning contributed to these results. Overall, macro managers' risk postures were leaning toward risk-on, which is a significant shift from last quarter, where we found managers on both ends of the spectrum. Risk levels, on average, were mid-range. However, many managers are running at or slightly higher than intended risk targets because of elevated underlying market volatility.

On the other end of the macro spectrum, the HFRI Macro Systematic Diversified Index —primarily CTA trend following and Global Tactical Asset Allocation strategies, was only up 0.3%. Many funds were on the wrong side of the equity markets in early September. Importantly, the known volatility distortion caused by November 3rd option positioning is prompting managers to prepare for manual overrides. The intervention is likely to result in tightening model risk parameters or outright reduction in risk utilization levels ahead of the election.

A Look at Flows

While hedge fund performance continues to improve and global interest rates appear pinned near zero for the extended foreseeable future, interest in hedge funds as alternative sources of return and for risk mitigation is on the rise. According to HFM, an encouraging $40 billion in inflows in July and August signaled a growing interest before the September stall. 4 Outflows tended to result from Event Driven, Managed Futures and Macro strategies, while regional flow data indicated that Europe and Asia Pacific have been the primary beneficiaries of recent inflows. Slow inflows, however, make sense to us.

Investors are finding the ability to commit capital to new hedge funds difficult during the COVID-19 environment, inhibited by limited on-site accessibility and restricted face-to-face activities. However, the managers who are seeing flows exhibit a combination of distinctive performance, strong virtual connectivity and regular information exchange with their existing investors. Today’s capital raising environment remains challenged. The strong momentum of four $1+ billion launches in Q1 abruptly halted, and the pipeline for the rest of the year has thinned. Except for risk mitigation strategies and dislocation-focused managers, most new fund launches sensibly have been postponed to 2021.

In our view, the medium- to long-term repercussions of COVID-19 will result in opportunities on the micro and macro side. Hedge fund managers who can make investments that take advantage of temporary transitions as well as permanent changes are in demand. The variety of active hedge fund strategies that structure trades to deliver large convex pay-outs or offer downside risk mitigation continues to grow and evolve. Investors continue to explore ways to deploy risk in more thoughtful, non-traditional ways as the outlook for the traditional 60/40 equity/fixed income mix becomes less and less compelling.

 
 

1 Source: Hedge Fund Research, Inc. The most recent six-month performance of the HFRI Fund of Funds Composite Index that exceeded the past six months’ performance was the six-month period ended March 31, 2000, which gained 21.6%, the highest six-month period on record.

2 Mergermarket, Global & Regional M&A Report 1Q-3Q-20

3 EY Global IPO trends: Q3 2020 Report and Dealogic

4 Hedge Funds in 3Q20, HFM, October 2020

 
 

Index Descriptions

While the HFRI Indexes are frequently used, they have limitations (some of which are typical of other widely used indexes). These limitations include survivorship bias (the returns of the indexes 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 indexes, and the index may omit funds, the inclusion of which might significantly affect the performance shown). The HFRI Indexes are based on information self-reported by hedge fund managers who decide on their own, at any time, whether or not they want to provide, or continue to provide, information to HFR Asset Management, LLC. Results for funds that go out of business are included in the index until the date that they cease operations. Therefore, these indexes 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 the HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. dollars, and have a minimum of $50 million assets under management or a 12-month track record.

Hedge Fund Research, Inc. (HFRI) Macro Index: The HFRI Macro Index consists of investment managers who 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, including 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 that movements in underlying macroeconomic variables may have on security prices, as opposed to equity hedge (EH), in which the fundamental characteristics of the company 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 where the investment thesis is predicated on the 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.

 
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.

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.

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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.

Global Pandemics. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (such as natural disasters, epidemics and pandemics, terrorism, conflicts and social unrest) that affect markets generally, as well as those that affect particular regions, countries, industries, companies or governments. It is difficult to predict when events may occur, the effects they may have (e.g. adversely affect the liquidity of the portfolio), and the duration of those effects.

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.

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Index data is provided for illustrative purposes only. Indexes do not include any expenses, fees or sales charges, which would lower performance. Indexes 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

 

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