Volatility has returned to equities, bond yields have fallen dramatically, and inflation fears have stoked demand for precious metals. That said, identifying hedge funds that will be successful is incredibly challenging in an industry with over 4,000 funds managing over $2.92 trillion of assets. Furthermore, given the unconstrained nature of most hedge funds, dispersion within each broad-based hedge fund strategy is much higher when compared to the long-only world, where different strategies are typically benchmarked to an appropriate index. Manager selection is an increasingly important component when deciding which hedge funds are best placed to capitalise in a post-COVID world.
12 months to August 2020 – Strategy Performance
In order to identify which hedge funds have the most to offer, one has to identify what problem hedge funds are being used to solve. Are they being used to diversify away from a traditional portfolio of equities and bonds? Or are they being used to gain exposure to a particular asset class in a more risk-adjusted fashion? We frequently see investors using hedge funds as a portfolio diversifier but then invest in hedge funds that are correlated to their existing investments, especially during market dislocations. The hedge fund industry is dominated by equity long short funds and data from Aurum’s Hedge Fund Data Engine show that most offer very little diversification benefits with the strategy having a correlation to MSCI World Index of 0.92 over the last five years and 0.81 since 2000.
Investors should have a clear understanding of the investment and risk management processes of a particular hedge fund and an appreciation of how it is likely to react in different market environments within one’s wider portfolio. Furthermore, ensuring a fund is operationally robust is arguably of the greatest importance.
While the opportunity set is positive, the current environment presents a number of challenges to managers; the prospect of multiple waves of COVID-19, the timing of a potential vaccine, the upcoming US election, and ongoing US-China trade tensions. So, which global hedge fund strategies have the most to offer in a post-COVID world? Arguably, strategies that are liquid and nimble may allow managers to hedge or reduce exposure rapidly if required. March was a timely example of how liquidity can dry up during a stressed scenario, prices gap down and managers struggle to cut risk. Investing in managers that are cognisant of this and are able to react accordingly is crucial.
Global macro funds have had many critics in recent years with many well-known funds struggling to generate attractive returns since 2008. However, 2020 has seen the renaissance of global macro with the environment providing a more fertile environment for the strategy.
The unprecedented nature of central bank intervention across the world has seen rates fall synchronously. Central bank independence continues to erode in many developed market economies with monetary and fiscal policy goals increasingly in tandem. What will be the result of the increasing indebtedness across the world? Will this ultimately lead to inflation? Or will the increasing levels of unemployment be deflationary? Global macro funds have a “go anywhere approach” and can often seek medium term thematic trades where they see the best risk/return opportunities. Recent themes have included notable positioning in precious metals and currencies. Gold, often seen as a hedge against inflation and currency debasement, has been a consensus macro trade of late, hitting all-time highs in August. Short US dollar positioning has also been a common theme as US support packages go further than most other countries. With rates effectively anchored at zero in the US and negative in Europe, fixed income volatility has fallen and macro traders are increasingly looking at currency markets to generate returns.
Global macro funds can also seek structural trades, where recurring patterns typically driven by investor flows that move markets on a repeatable basis are identified. An example of this behaviour can be observed during the final few weeks of each quarter end as rebalancing by large institutional portfolios can lead to significant buying or selling pressure. The sharp sell-off in equities during March, helped support the notable buying pressure during the final two weeks of the month as portfolios rebalanced to fall in line with their strategic asset allocations. Clearly, in this instance, there were other competing factors, as is often the case, but making small bets on multiple recurring events can be a profitable strategy for global macro funds. The effects of COVID-19 could exacerbate these moves if flows are substantial going forward.
The flexible nature of global macro funds are also often seen by some investors as a hedge against a rising rate environment. While it is not widely anticipated that rates will rise in the near future, one has to take increasing amounts of duration risk, credit risk or liquidity risk in the search for yield, thus increasing risk on the downside.
The term multi-strategy is very broad and they have the ability to dynamically allocate capital depending on where the best opportunity set lies. Many multi-strategy funds have significant allocations to discretionary long short equity strategies, quant equity strategies, global macro, fixed income relative value, credit and event driven strategies.
Multi-strategy funds include of some of the strongest hedge fund businesses in the industry. This gives them the ability to attract the best talent, invest heavily in systems and employ incredibly sophisticated risk management frameworks. The resources available to the top funds are almost unparalleled and they have demonstrated an ability to generate consistent returns, while protecting capital over nearly 30 years.
A key component of many multi-strategy funds are discretionary long short equity strategies. As previously noted, the majority of equity long short funds offer very little diversification benefits primarily due to the fact that the majority are nearly always structurally net long equities, and as such, often struggle in equity market sell-offs.
Conversely, multi-strategy funds take a more market neutral approach to equity long short investing, typically employing sector specialists with a clear understanding of sector dynamics and an appreciation of relative outperformers, while limiting existential market risks. In a post-COVID word, single stock equity dispersion has returned as there will be winners and losers resulting from the current environment. Fundamental stock pickers with a trading orientated approach should therefore thrive in this environment and those with a lower net exposure should also be better placed to protect capital in an equity market sell-off.
Quant equity and statistical arbitrage strategies also have lot to offer in a post-COVID world. These strategies are typically dependent on elevated levels of volatility and volume to be successful, as such the last two quarters have proven to be an exceptionally good environment for these strategies. A continuation of this environment should continue to be positive.
In any scenario, investors should start by asking themselves what problem they are looking to hedge funds to solve. While global macro and multi-strategy funds seem well placed to weather the current environment, strong managers in any strategy can still deliver returns. March was an example of how bad liquidity can get in fixed income and equity markets so selecting the best managers with a careful eye on liquidity is of the utmost importance. We believe funds with a market neutral or variable net bias should be best placed to protect capital and offer investors the best risk-adjusted returns in a post-COVID world.