Hedge fund strategies can thrive on uncertainty – even if fundamentals are unclear
Bruce Amlicke, Chief Investment Officer, UBS Hedge Fund Solutions
Today, markets gyrate with each headline from Washington. As it pertains to global trade, headlines have made some sector and geographical investing quite challenging. While over time these news flashes may have a diminishing impact on markets, participants continue to price in higher uncertainty and thus volatility. This can be evidenced not only in cross-asset implied volatilities but also in more idiosyncratic areas like cross border merger deals.
In addition, with signs of further interest rate hikes, market participants have begun to view the US as if it is in the latter stages of economic expansion. The aging of the bull market has shown up as asset allocator shifts typical of late cycle phenomena, such as towards assets tied to inflation (i.e. financials and commodities) are occurring.
The ways that market technicals drive volatility were exemplified in Q1 2018 when the dramatic volatility surge (in the equity market selloff) forced further reductions of equity exposure. While initial catalysts for February’s moves were possibly as mundane as investors rebalancing portfolios after a strong January start for equities, the price moves were exaggerated by technical selling from systematic strategies including risk premia, risk parity, volatility targeting, short volatility positions and trend-following strategies. Interestingly, most hedge funds were able to maintain their gross exposure due to strong performance, which supported alpha during the risk-off move.
Fundamentally, the inflation backdrop remains uncertain, regardless of fiscal stimulus. While the output gap in the US does appear to be closing and rate hikes have accelerated, long-term deflationary trends (disruptive technology, the demographics of developed markets, the globalization of labor and consumption) are very real and possibly underappreciated forces. Coupled with the sudden deterioration in European economic data, and a surprisingly firmer footing of the Asian economic cycle, the picture is less clear. It is therefore possible that inflation could stay muted for some time despite market expectations.
In Equity Hedged, we expect global alpha generation to be positive, but muted after a period of strong performance. All eyes are watching technology and momentum. Market technicals may again come into play if weakness persists, potentially forcing managers to de-risk from elevated levels. In our Equity Hedged allocations, we prefer catalysts over crowded thematic approaches. We expect geography will continue to matter and we prefer exposures in Asia and Europe over the US.
Towards the end of Q1, overbought credit markets retraced some of their recent gains and spreads widened. This is natural in a more volatile market environment. However, we believe the story to follow closely is how expected US interest rate hikes begin to impact credit markets. With leverage high in corporate America, companies that falter may start to run into difficulties refinancing or servicing debt. In the meantime, we find high quality asset-backed and cash flowing securities, including mortgage credit and reinsurance to be attractive. This is an environment where active management and agile portfolio management can pay dividends.
Relative Value strategies can ideally deliver a consistent return, with additional alpha if volatility remains elevated. Our conviction in Fixed Income Relative Value is particularly strong due to increased rate volatility and flows, despite an overall flatter US yield curve. Idiosyncratic risk and return dispersion also led to a strong quarter for both statistical arbitrage and fundamentally-based quant strategies. There have also been tailwinds in the event-driven space due to tax reform, deregulation and repatriation.
The discretionary trading community has largely been involved in reflation themes over the past year, and it finally paid off recently as US rates moved higher and curves flattened. Tactical trading in equities has provided strong gains for many who took advantage of cheap implied volatility in Q4 2017 to establish punchy upside exposure to a move higher in equities—and then were able to take gains before markets reversed. Emerging markets have also continued to provide good alpha, despite some wobbles amid risk-off sentiment. Long EM local rate trades (Greece, Argentina, Egypt) and short US rates (hedges) proved profitable on both the long and short side of portfolios. We are cautious about overall EM beta exposure and confident that managers can capture a more two-way opportunity set this year.