Trade wars, shifting expectations for rate hikes in the US, political crises in Brazil and Italy, fiscal crises in Argentina and Turkey, and a resurgent US dollar made it a very tough quarter for risk assets. Volatility remained at elevated levels for the first half, falling gradually as the quarter went on, with the S&P 500 and Euro Stoxx 50 ultimately ending the quarter up 2.9% and 1.0% respectively.
In Europe, perhaps the most significant event was the fallout from the Italian elections as the anti-establishment Five Star Movement and the right-wing Lega, two populist and Eurosceptic parties, looked to form a coalition. Both parties have been very vocal in promising expansionary fiscal policies and openly critical of the euro and Italy’s membership of the EU. This spooked investors and sent the yield on Italian 2 year bonds up 154bps to 2.73% on 29th May, as the prospect of the two parties forming a government looked more likely, calling into question Italy’s future membership of the EU. This was painful for holders of Italian bonds, as liquidity evaporated in one of the largest sovereign debt markets in the world.
As we saw in Q1, the search for yield led to some investors taking excessive risk. The Italian/German spread compression trade was a classic example of this, whereby traders took leveraged bets on the yield between the two countries converging, while earning a positive carry. This trade had worked very well over the 12 months to mid-May, as the ECB’s unprecedented bond buying program had helped drive down the spread on the 2 year to 25bps, having been under 100bps for most of the preceding five years, against a backdrop of improving sentiment surrounding Europe’s periphery. These gains evaporated as the 2 year spread blew out by over 300bps, hitting 3.50% as Italian bonds sold off and a flight to quality drove up German Bunds.
A significant part of Aurum’s due diligence process is to ensure that there is a strong culture of risk management. Some of the macro hedge funds held by Aurum had the trade on, but had been reducing exposure to it as the spread got tighter and the probability of the coalition forming increased. This risk management discipline is what we expect, as the trade had turned into a classic carry/short vol trade with increasing left tail risk.
The broader hedge fund industry struggled during Q2, with the HFRX Global Hedge Fund Index up 0.17%. All funds managed or advised by Aurum outperformed this index, with US dollar share classes returning between +0.6% and +1.7%.
Aurum’s multi-strategy funds continued to be a strong source of alpha across all portfolios, building on their impressive start to the year, with all invested funds up for the quarter. A strong culture of risk management and the ability to dynamically deploy capital to different portfolio management teams makes them extremely attractive in this environment. Notable gains were made by fundamental equity teams adding stock specific alpha through earnings season.
Performance in macro was mixed, with the majority of Aurum’s invested funds returning between -1% and +1% for the quarter. There was some pain for those with an emerging market bias as the political events in Argentina, Brazil and Turkey weighed on returns. Somewhat more positive was the performance of funds taking a more bearish stance on global growth, with returns generated from short semi-conductors and short China positions.
In event driven, Aurum’s bias towards low beta idiosyncratic event strategies, namely hard catalyst merger arbitrage, index rebalancing and share class arbitrage, was rewarded, with both invested funds up for the quarter, one by 3.6% and the other by 5%. M&A ran at record levels for the first half of 2018, with global deals announced reaching $2.5 trillion. A key feature was the resurgence of mega-deals, with a record number of deals above $10bn. The media and telecoms sectors in particular continued to be a rich source of returns, and with corporate cash at elevated levels and US tax reforms encouraging companies to repatriate even more cash back to the US, the future outlook for deal activity remains extremely healthy.
Systematic funds on the whole detracted from performance across most portfolios, as pattern recognition strategies in the US struggled during April and May. How much this had to do with Trump’s trade wars is unknown, as there is little historical data on the issue. June was also a tough month for most systematic funds, as a rumoured deleveraging event provided a strong headwind.
Two of Aurum’s equity long/short funds performed well, returning +5.2% and +2.1%, while one finished the quarter marginally negative. Notable gains were made from longs in the industrial cyclicals sector and in technology.
While the current environment is challenging from an economic and political standpoint, the majority of Aurum’s managers are optimistic about the opportunity set that this will bring. The first half of 2018 certainly seemed more eventful than 2017, and we look forward to the opportunities this affords the portfolio as we enter the second half of the year.