Aurum’s Quarterly Report – Q4
It is always pleasing to report that the Aurum portfolios have generated positive returns, and this was the case across nearly all funds and bespoke accounts in 2018. In a year that saw a notable shift in sentiment, the final quarter was particularly tumultuous for risk assets across all classes and most geographies. Whilst the Aurum multi-manager portfolios were not completely immune to these market gyrations, all finished the year between -0.03% and +4.3%. This compares favourably to the wider hedge fund industry; the HFRX Global Hedge Fund Index finished the year -6.7%.
Global equity markets tumbled throughout October as lower-than-expected earnings, rising yields and continued trade war fears weighed on investor sentiment. After a slight rebound at the beginning of November, equities sold off again, and then rallied again during the final week of the month as investors seemed encouraged by the prospect of improving trade rhetoric between the US and China at the G20 summit in Argentina. However, the arrest of Huawei’s CFO in Canada at the request of the US ensured that any boost to investor sentiment in December was fleeting, with equities taking a further hit. The S&P 500 finished the quarter down 14.0% to end the year -6.2% while the MSCI World Index lost 13.7% and finished -10.4%, each suffering its worst performance since 2008.
While moves in equity markets caught most of the headlines, the move in US treasuries was of equal significance. Jerome Powell commented at the beginning of the quarter that US rates were a “long way from neutral”, pushing yields higher with US 10 year yields touching 3.20%. However, this was short-lived; yields plummeted from the beginning of November as investors flocked to safe haven assets, with US 10 year yields finishing the year at 2.68%, only 0.28% higher than the beginning of the year, despite four rate hikes in the interim.
Against this backdrop, Q4 was extremely challenging for most hedge fund strategies. Whilst the negative return overall for the quarter for the funds and portfolios managed or advised by Aurum was disappointing, there were bright spots, with the macro, systematic and event driven allocations each contributing positively over the three months.
It is impossible to ignore the fact that multi-strategy funds had their worst quarter since Q1 2016, which followed a similar period of market stress. Sharp sell-offs in equity markets can lead to a cascade effect as portfolio managers initially sell high-beta stocks and cover crowded shorts. These market moves can the lead to a systemic deleveraging effect that manifests in losses for market neutral equity strategies. As stop-losses and other risk limits are hit a negative feedback loop is created, as longs are sold down further and the shorts covered, as portfolio managers react and reduce overall gross exposure.
While broader hedge fund losses in October were driven primarily by beta exposures, November’s losses were primarily alpha-driven, as US equity markets ended the month in positive territory. This “negative alpha” was confirmed by data received from prime brokers, which showed that daily losses to momentum factors were much more noticeable in November than in October. The multi-strategy funds in portfolios managed or advised by Aurum typically have some of the tightest risk management frameworks in the industry, but can nevertheless face challenges as a result of these types of deleveraging event.
Experience has taught us that, once the deleveraging is complete, opportunities present themselves on both the long and the short side. This was certainly the case in December, as performance for all multi-strategy funds in the Aurum portfolios was positive, despite equities having their worst month since 2011.
Macro had its strongest quarter of the year, and proved to be a positive diversifier to returns. Funds with a negative outlook on global growth produced outsized gains in October as equity markets tumbled sharply. Other key performance drivers in Q4 were long Brazilian rates positions, as the election of right-wing Jair Bolsonaro as president was viewed positively by the market.
Systematic funds contributed positively to overall returns in Q4. Fast technical strategies and short-term futures strategies performed well, capitalising on a higher volatility environment than that seen in the previous two quarters. Pattern recognition and statistical arbitrage strategies, however, continued to struggle and detracted from returns. The performance of systematic funds held in the portfolios as a whole was disappointing, in what has been a tough year for the strategy.
Performance of the event driven strategy was positive for the quarter, finishing a very strong year overall. Gains were made from a pending merger in the media sector as regulatory agencies in Europe and China approved the deal, with antitrust approval in Brazil being the last hurdle to overcome. Gains were also made following the completion of a vertically integrated merger in the pharmaceuticals sector. While deal flow was slower than in the first half of 2018, the future outlook for deal activity remains healthy.
Reflecting on this year's events as a whole, it is little wonder that few investors have managed to capitalise on any one theme. The sharp change in investor sentiment during Q4 caught many off guard, as the best performing strategy over the last few years, “buy the dip”, ended in dramatic fashion, and the repeated headlines in August of “the S&P reaching all-time highs” now seem like a distant memory. That said, much of the investment community expressed apprehension and nervousness for much of 2018, though Trump’s tax cuts proved a significant tailwind to corporate earnings into Q3, buoying equity markets. With the benefit of hindsight, this seemed to blind investors to the ongoing trade dispute between the US and China (and the rest of the world), the beginning of the global central bank balance sheet unwind and increased fears of a global economic slowdown following weak economic data from both China and the Eurozone. Aurum has been anticipating a return of volatility for some time and, over the last 18 months, has been increasing exposure to funds that have the flexibility and historical pedigree to outperform in a volatility spike and/or a move to a more bearish market scenario. These additions have had a positive impact on the portfolios during the quarter and allocations to funds with these characteristics are expected to increase in 2019.
Aurum’s role is to identify hedge funds that protect capital and deliver a return stream that is not market-dependent or beta-driven. While the broader hedge fund industry struggled during much of Q4 2018, the performance of Aurum’s underlying hedge funds was encouraging, particularly in December, with many bucking the trend when compared to the broader hedge fund industry. Aurum remains attentive to a range of market and geopolitical risk factors and, in the firm’s 25th year, is optimistic that the funds and portfolios it manages and advises will be able to navigate the year ahead and beyond.