The broader hedge fund industry struggled during Q3, with the HFRX Global Hedge Fund Index down 0.4%, bringing its year to date performance to -1.2%. By contrast, all funds managed or advised by Aurum outperformed this index for the third quarter running, with US dollar share classes returning between +0.8% and +2.4% over the quarter and up between 3.0% and 7.3% YTD.
Unlike the first and second quarters, when the short VIX trade and Italy/Germany spread compression trade came to an end, there was no single material market event that defined the third quarter; rather, it was largely a continuation of the events that were unfolding during the first half of the year. Trade war rhetoric between the US and China continued to escalate, doubts remained as to whether Italy’s new coalition government would successfully deliver a credible budget, and pressure persisted in emerging markets, with Turkey and Argentina raising interest rates to 24% and 60% respectively to contain a sharp devaluation of their respective currencies. Global growth remained positive on the whole, though it was less synchronised, with the US clearly standing out as the leader.
Equity markets were strong in the quarter, although once again in the US large companies outperformed, driven by large technology names. Momentum names outperformed (DJ US Thematic Market Neutral Momentum Index: +2.7%), while value continued to struggle (DJ US Thematic Market Neutral Value Index: -3.9%). In fact, value investing has been a particularly tough space for a protracted period of time, with the same index now down 12% YTD. We are aware of a number of value-oriented equity hedge funds that have had a torrid time. Risk premia/factor-based funds are also struggling, with one high profile multi-billion dollar US-based fund down well over 10% so far this year.
Trump’s US tax reform improved profitability for US companies, contributing to an exceptionally strong Q2 earnings season, with year-on-year earnings growth of the S&P 500 at 24%. Wage growth rose to its highest level since 2009, which propelled US consumer confidence to its highest level since 2000. US equities were well bid during the quarter, with the S&P 500 hitting new all-time highs on a number of occasions in August and September. Somewhat counterintuitively, this created a challenging environment for many fundamental equity market neutral strategies. The strategy requires material price movement (volatility) and single stock price dispersion, both of which have been at historically low levels. It was therefore pleasing to see Aurum’s multi-strategy funds (that contain a significant risk allocation to multi-PM fundamental equity market neutral strategies) successfully navigating the quarter, with performance ranging between 2% and 4% for the quarter. Notable gains were made in the healthcare sector as managers rotated away from technology and into more stable defensive names with strong profitability.
Looking forward, we believe that exposure to low beta equity specialists gives the optionality to benefit if dispersion in stock prices increases and markets become more fundamentally driven, but such funds should still be able to generate returns even if the current environment persists. The low net market neutral approach should also provide some defensive qualities in the event of a market sell-off.
The strength of the US economy caused the Fed to tighten faster than many expected. Indeed, at the beginning of the year the futures market priced in a 20% probability for three rate rises during 2018. Three have since occurred and the market is pricing in a 75% chance for a fourth by the end of the year. US 10 year yields pushed slowly through the psychological 3% barrier to finish the quarter at 3.06%, from 2.86%.
In Aurum’s macro bucket, gains from fixed income RV were offset by losses in emerging markets and by macro managers with a bearish view of the world. While it has been a challenging environment, with only two funds generating positive returns for the quarter, monetary policy is moving at two different speeds, with the US raising rates far quicker than any other G7 country. This should provide opportunities going forward. Furthermore, in emerging markets, while the cocktail of rising interest rates in the US and the idiosyncratic events in Turkey, Argentina and Brazil has caused some pain, the increase in dispersion between countries should also provide opportunities going forward.
In event driven strategies, Trump’s policies had a mixed effect on M&A. On one hand, the first major casualty of the ongoing trade wars between the US and China emerged in the merger arbitrage space, after Qualcomm walked away from its $44bn bid for NXP Semiconductors after failing to secure Chinese regulatory approval, leading to notable losses for many event driven funds. On the other hand, Trump’s tax cuts and cash repatriation continued to provide a tailwind for corporate activity. The end of the quarter also saw the conclusion of the bidding war between Comcast and Fox for Sky. This was a massive trade for the event driven community. The other material news in the merger space related to what seemed to be a relaxation on anti-trust issues, following the overruling of the DoJ objection to the AT&T / Time Warner deal; this has paved the way for an acceleration of vertically integrated mergers, with a number of healthcare deals on the horizon. Aurum Research’s Head of Research, Tim Wilkinson, takes an in-depth look at M&A and the outlook for event driven hedge funds in his research piece ‘M&A Plays the Trump card’
Both of Aurum’s invested event driven funds had positive quarters; their relatively small size, when compared to their larger competitors, has allowed them to be nimble and trade around positions, while both were able to benefit significantly from the Sky bidding war.
Systematic funds on the whole detracted from performance across most portfolios. Many funds have recently faced two major headwinds: increased crowding and competition, as well as a period of ultra-low realised stock price volatility. However, our focus is to identify those funds that we believe offer genuine differentiation in the factors or approach driving their returns. We also expect that these funds should be able to perform well in a move to a higher volatility environment.
At the time of writing, Q4 has started somewhat precariously, with equities and bonds both selling off at the same time. This has had particular ramifications for those following a ‘risk-parity-like’ approach, as we saw one of the worst weekly sell-offs since 2010 for this strategy earlier this month.
While the current environment is even more challenging than at the start of the previous quarter, Aurum’s portfolio construction process ensures there is some exposure to funds that are positioned to benefit from a high volatility environment while demonstrating a proven ability to protect capital in a more bearish market scenario.