Hedge funds: here to stay
We believe the same cyclical and structural dynamics in markets that enabled strong hedge fund performance over the past two years are set to continue going forward, creating a favorable environment for hedge funds.
Kevin Russell
CIO, O’Connor
Find detailed insights below
Find detailed insights below
Hedge funds have seen strong performance over the last two years, capitalizing on market dislocations and structural changes and these have created alpha opportunities that hedge funds are well positioned to take advantage of. We see those trends continuing, as market uncertainty continues to cause market dislocations.
Our preferred indicator for investor risk appetite is interest rate volatility, measured by the MOVE Index (Merrill Lynch Option Volatility Estimate), which spiked in first-quarter 2020 and again in early 2021. This year’s elevated interest rate volatility has brought with it both risk aversion and violent factor rotations within equity markets.
Rising interest rate volatility suggests reduced investor confidence
Rising interest rate volatility suggests reduced investor confidence
Interest rates serve as the fulcrum point for the economy, providing a comprehensive view about growth, inflation, and policy. Obviously, interest rates play a central role in valuing any financial asset. But beyond the absolute level of rates, interest rate volatility creates equity market rotations and dislocations in the market, and we’ve seen that this year.
Put simply, when interest rate volatility is high, certainty about economic conditions and confidence in asset valuations is low, often manifesting itself as risk aversion amongst relative value investors, especially those who operate on leverage.
For the last decade or longer, investors became accustomed to low interest rates and expected interest rates and growth to continue at a low level. Growth, quality and bond-proxy names performed for over a decade under this regime, but now we are starting a new economic cycle and investors are going to have to adjust those rotations and exposures.
That process creates tremendous opportunities for investors like ourselves. We monitor and trade around factor exposures: in the first quarter of this year we achieved an entire year's worth of rotations in the market, from a consensus growth position towards one more balanced with value and cyclicals.
Financial markets generally do a very bad job when they first have to adjust to new economic realities and new market risks. And so we see a lot of rotations and overcorrections, creating tremendous relative value opportunities.
Looking across asset classes, we believe equity markets have very two-sided risk. Duration assets have significant downside. Credit markets are largely priced for perfection, in our view.
Six mega trends creating opportunities
Six mega trends creating opportunities
As for structural opportunities, we've been focused on six mega trends happening within the financial markets that are now creating systematic alpha opportunities for investors like ourselves.
Size of US credit markets
The corporate credit markets have exploded in size, while banks and broker dealers who carry inventory are just too small relative to that notional amount of corporate debt, creating tremendous relative value opportunities for investors.
Special purpose acquisition companies (SPACs)
As of the middle of the second quarter of 2021, USD 91 billion of SPAC stocks looking for transactions, became a very important mechanism for emerging growth companies to come public, creating compelling relative value opportunities.
The environmental space
Against the backdrop of climate change, which is causing changes in consumer preferences, a dynamic regulatory landscape, and is generating significant shifts in capital expenditures. Those are the raw materials for dispersion of returns.
Private credit
Disintermediation of banks as hedge funds and asset managers extend credit directly to borrowers. Particularly in the case of riskier and more complex loans, banks are not willing and able lenders in many cases. This offers one of the most attractive, risk-adjusted yield and total return profiles available in the financial markets for private credit investors.
Trade finance
We are seeing compelling opportunities relative to what we see in investment grade and high yield bonds. These trade finance claims have a shorter duration, higher yield, lower default probabilities and higher recovery than corporate bonds, yet are complex enough that most investors cannot participate.
China
At 17%1 of global GDP, China has been working hard to make their markets more accessible and more efficient. This was underscored late last year, when China eased foreign access to its capital markets through a reform of its Qualified Foreign Institutional Investor (QFII) and Renminbi QFII programs that will allow investors to trade directly with Chinese banks and broker dealers and create an onshore stock lending market over time.
The current macro environment provides what we consider a perfect backdrop for hedge fund investors: a shifting macro picture along with ongoing structural alpha opportunities and a relative dearth of capital in relation to the opportunity set.
