It’s now time for “liquid alternatives” to stand up and be counted. The last real opportunity for many hedge funds and liquid alternative strategies to demonstrate their diversification benefit was in Q4 2018, and the outcome was broadly underwhelming, writes Toby Goodworth, managing director of bfinance, a UK financial advisory company.
As one leading alternative manager said in a recent memo, “the COVID-19 pandemic falls into the category of “emergent phenomenon”. This is a term borrowed from the world of physics, but, applied to markets, the key point is that we are dealing with a new phenomenon which is not well understood, either in terms of medical science, or human effects and reactions.” Investors and asset managers must now utilize contemporaneous empirical results to improve their understanding, rather than relying on previously assumed knowledge or past experience. As with 2008, it is highly likely this will result in changes to investment philosophies, processes, and portfolio allocations.
It’s important to be realistic: hedge funds are not explicit hedges or “silver bullets”, and negative returns do not mean a strategy is broken. Yet one would hope to see a number of diversifying strategies delivering good results in a period such as this one – however unusual the current crisis may be. So far in March we are seeing huge dispersion in returns – not just between liquid alternative strategies (of course), but between individual managers operating very similar strategies.
Losses aside, market environments like this are useful to help sort the “wheat from the chaff,” determine the robustness of investment process, and understand whether it has actually delivered as expected. Goodworth examines the following strategies: explicity long volatility or tail protection strategies; global macro; equity market neutral; event driven; alternative risk premia and relative value.
Explicit long volatility or tail protection strategies
Finally – some payback on all that “theta bleed” through the years of artificially low volatility environments. The recent equity sell-off is significant, and of a magnitude that should be well beyond the convexity attachment point for many tail risk protection or explicit long volatility strategies.
VIX is currently in the mid-60s with huge daily whipsaws in DM equity markets (cf. VIX at 80 in the worst of 2008). As such intra-month gains in such strategies should be meaningful: several managers are up 10-30%. The challenge here will be the ability to monetize these gains rather than see paper profits disappear if markets recover. Managed Futures, CTAs & Systematic Macro Managers in strategies that are implicitly long-volatility, such as CTAs and Systematic Macro, have held up well so far.
In the month to date, profits have typically come from long-bond and short-energy exposures, resulting from the unfortunately timed oil supply war between Saudi Arabia and Russia. This tailwind has more than offset their recently tapering long-equity exposure. At the time of writing, the SG trend indicator index was up +7% month-to-date. Many Systematic Macro strategies are built around behavioural phenomena – fear and greed – while CTAs seek to exploit persistent trends such as herding. As such these strategies should be in their element at a time when reliance on fundamentals is temporarily less important.
But it is important to remember that these are inherently directional strategies, which profit from dynamically adjusting to market conditions. There are no guarantees they will be correctly positioned for every market dislocation to the extent that they were in 2008. Indeed, with a particularly fast sell-off in March (faster even than ’08); whether managers were able to profit was a matter of (path dependent) luck as much as skill.
A number of discretionary Global Macro managers are making significant gains from their rates books in March. As with Systematic Macro, discretionary Global Macro strategies should be more adept at handling topdown macro driven markets than their fundamental bottom-up hedge fund peers. That said, the events of March are clearly exogenous, and will therefore be far more challenging for managers. We expect some big variations in manager specific performance here – this is a particularly heterogenous space. Yet we would broadly observe that Global Macro managers have historically performed better in periods of moderate / heightened volatility rather than the recent period of artificially low / suppressed volatility.
There is potentially a lot of opportunity for conviction-driven thematic trades to be added opportunistically, with many Macro managers likely to see the recent turbulence and dislocation as a potential entry point for building on existing longer term themes, or perhaps to introduce entirely new themes.
Equity narket neutral
Month-to-date, these have given broadly flat-to-negative (mid single digit) returns. This is not unexpected, and on a relative basis still represents a useful diversifier. EMN strategies typify the “market independent” strategy group, which should be differentiated from the strongly positive convex (in theory) diversifiers listed above. Across the more typical directional Equity L/S managers, we have seen average net exposures reduce through Feb and March, but not excessively (now around 65% from 75%), with gross books remaining at about 250%.
The alpha generated by stock picking across many Equity L/S and Equity Market Neutral funds was very strong up until mid-March, but this appears to have tailed off in the subsequent days. (Note: the FCA has now banned short-selling on a number of European stocks – a tool that has also been employed in previous crises.)
Broad Event Driven strategies are down a couple of percent month-to-date, and Merger Arbitrage is faring slightly worse. One would expect some impact to Event Driven strategies, partly due to the moderately long equity bias implicit in some Event strategies, but more pertinently from deal breaks or the very large indiscriminate spread-widening, which has been induced by the uncertainty of the dramatically altered environment. (Note: deal breaks will be crystallized losses, whereas spread-widening could present opportunities for managers to build into conviction positions at attractive levels.)
The poorer performance of Merger Arbitrage requires more explanation. This is somewhat counterintuitive: hard catalyst strategies should typically do a little better in a scenario like this, since they are less correlated to equity markets. Multi-Asset Well-balanced portfolios with risk parity-type construction will have fared well in March, so far.
Strategies with an ‘Absolute Return’ focus should perform better than those with a ‘Total Return’ focus in this climate, and early performance indications for March so far suggest this is indeed the case, with the GARS-like group seemingly holding up well through the quarter (flat or slightly negative returns). Similarly, those that have flexibility within their absolute return strategies to dynamically manage risk should have the ‘tools in the toolbox’ to navigate the rapidly evolving environment, more through risk control than through trying to time the market.
Alternative risk premia
The classic ‘academic’ risk premia are holding up well. Trend-following is the star, delivering a strongly positive result from long-bond, short-energy. The more complex ‘practitioner’ premia, such as Relative Value, are struggling in comparison, with the volatility arbitrage or dispersion (single stock vs index) type strategies having particular difficulties.
Sharp dislocations, high volatility, fundamental unpredictability in markets – these are not ideal market conditions for relative value strategies. Volatility arbitrage, dispersion / spread trade (index vs. constituent), correlation trading, carry strategies and the like are generally seen as ‘convergent’ strategies, meaning that they profit from markets remaining in their current state or evolving in a predictable way (e.g. mean reversion).
They are highly technical and complex strategies, often using comparatively high levels of leverage to exploit small mispricings. Generalizing across the broad range of approaches and managers, they have typically given negative returns in March month-to-date – ranging from low single-digit to high single-digit losses depending on their compositions and target volatility or gross leverage. Due to their complexity, many managers in this space have been reducing risk across portfolios, and therein crystallizing some of these mark-to-market losses.
Note: these strategies are often packaged in a multi-strategy way, either as part of a complex alternative risk premia strategy or in a quantitative multi-strategy hedge fund.