Strategy Outlook

In Q1, UBS Hedge Fund Solutions’ (“HFS”) Broad Based Diversified strategies generated positive returns amid a broad rally across financial markets.

We generally saw gains across most underlying strategies during the quarter. Equity Hedged was the top-contributing strategy as a restoration of market breadth and dispersion in equity markets bode well for alpha generation, with managers specializing in the technology and biotechnology sectors producing meaningfully positive returns. Performance was weakest within Trading. The resilience of the US economy and higher-than-expected inflation data tempered expectations for rate cuts in 2024, which generally resulted in losses for discretionary macro managers’ steepener and long rates positions. Finally, although Q1 was notably positive for CTAs (driven by long exposure to equities), it did not have a material impact to performance given our limited exposure to the sub-strategy.

Looking ahead, we believe that absent a more material spike in inflation (which is not in our base case), policymakers will prioritize growth objectives, which in turn, should be supportive of risk assets. Having said that, we are beginning to witness some signs of a possible slowdown in economic activity in the US. Labor markets have become more balanced, and with headline inflation catching up to nominal wages, real wage growth is expected to flatten this year. In addition, small business confidence has waned, possibly accelerating the pace of layoffs, while credit card delinquencies for the lowest income borrowers have surpassed pre-pandemic levels. As such, we expect underlying conditions to be more conducive to rate cuts in the second half of the year.

A relatively healthy economy and a lifeline from the Federal Reserve (Fed) continue to underpin our view that the likelihood of recession is low. With this friendly baseline expectation, we are satisfied with our increased beta profile but are not inclined to add more directionality for the time being (especially in corporate credit where spreads have compressed to historical lows). We continue to favor more fundamental Equity Hedged strategies. AI, GLP-1, the energy transition, and nearshoring are only just a few of the secular alpha themes in play for stock pickers and are best represented in the US. On the other end, we have lowered our forward-looking return estimates for fixed income relative value trading (FIRV) strategies, primarily driven by our expectations of declining interest rate volatility. As a result, we have reduced our target allocation closer to our long-term average after having maintained an overweight position for the past two years. Despite a lackluster start for discretionary macro strategies, we continue to maintain a core allocation. We think that diverging central bank policies and mounting geopolitical risks should offer more opportunities than in 2023. We also continue to prefer discretionary approaches over systematic as we believe the former can quickly adapt to regime shifts and geopolitical crisis, serving as a more effective tail hedge in portfolios.

Trading

Within Trading, we maintain core allocations to developed market (DM) macro managers despite our expectations for low risk levels after a difficult Q1. However, the macro divergence across regions has become more pronounced which should lead to variability in central bank policies, creating directional and cross-regional RV opportunities (e.g., ECB vs. Fed). Furthermore, we believe that the strategy can offer positive convexity should there be a more pronounced deterioration in economic conditions. For emerging market (EM) discretionary macro managers, the opportunity set remains attractive given the ongoing central bank easing cycles along with the Fed potentially retaining a more dovish stance. Geopolitical risk and upcoming elections are still likely to present trading opportunities for both DM and EM macro managers. We hold a neutral outlook for systematic trading. Given the high rates environment coupled with the lower volatility and increasing dispersion in markets, we believe the strategy is expected to deliver slightly more mixed but positive performance. We plan to maintain a smaller allocation to commodities with a focus on gas and power strategies, complemented by strategic longs in the less correlated green materials theme. We expect rangebound price action in oil and US natural gas but believe there could be upside for metals linked to electrification, driven by dwindling green transition materials supply, recent price weakness, and secular demand growth dynamics.

Relative Value

Within Relative Value, fixed income relative value (FIRV) remains a core allocation, but we are reducing our target weight. Our return expectations are slightly lower for the strategy as rate volatility is expected to moderate as inflation settles to central bank targets. Position concentration is also likely to provide headwinds for the strategy (particularly in a deleveraging scenario). Our outlook for capital structure / volatility arbitrage remains positive. We anticipate a continued surge in corporate actions and new issuance to anchor solid returns for the strategy over the near term. We continue to maintain a neutral outlook on quantitative equities, preferring statistical arbitrage strategies as opposed to fundamental. We maintain a small allocation to merger arbitrage strategies. We expect M&A activity to remain subdued as we approach US elections. Furthermore, the regulatory environment continues to weigh on the strategy while geopolitical dynamics reduce the odds of success for cross-border transactions.

Equity Hedged

Equity markets have been increasingly driven by fundamentals –and less so by macro narratives, creating an environment more conducive for stock picking. Looking ahead, we expect the backdrop to remain similar and, as such, seek to build our exposure to fundamental strategies. We prefer to position ourselves with sector specialists investing in alpha-rich themes in the energy, technology, and biotechnology space. We have also begun allocating to event-driven equities given our expectation that a benign macro backdrop should usher in a resurgence of activity in capital markets, including IPOs and rights issues. Outside the US, Japan remains our favored geography as the country is likely to benefit from a virtuous cycle of inflation and growth, heightened by tailwinds from corporate reform.

Credit/Income

Within Credit / Income, we do not anticipate increasing our exposure to income-focused strategies over the near term after having grown this allocation over the past several quarters. As credit spreads have compressed to multi-decade lows, we believe this could provide a good set-up for future volatility, benefiting corporate long / short strategies. In reinsurance / ILS, we plan to maintain exposure, however, we may tactically manage exposure to mid-year contracts depending on early weather analysis. We also expect to maintain our agency MBS exposure, with a focus on derivatives. The segment presents attractive carry and reasonable valuations, particularly relative to fundamentals, although spreads have tightened. We remain underweight long-biased and distressed in anticipation of better entry points later in the cycle. Corporate fundamentals continue to slowly deteriorate, with defaults and liability management exercises starting to pick up.