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James Williams, Hedgeweek

2016 augurs well for non‑directional relative value strategies

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The actions of central banks over the past few years have been particularly hard for hedge funds, especially fundamental stock pickers, and whilst global macro and CTAs have been able to make some solid returns (the latter more in 2H14), there's been precious little to celebrate in hedge fund land.

According to Preqin's latest global hedge fund survey, 33 per cent of investors felt that hedge funds had fallen short of expectations in 2015. Fund managers shared this sentiment, with 40 per cent saying that they too felt performance had lagged; the average hedge fund returned just +2.02 per cent. 

Central banks have continued to engage in economic alchemy in 2016, obsessed with the Philosopher's Stone equivalent of creating inflation whilst at the same time driving up equity valuations that simply bear no resemblance to their underlying economies; the US being the case in point. 

Following Haruhiko-san's decision to cut Japan's main interest rate to -0.1 per cent – a failed negative interest rate policy that far from weaken the yen has had the opposite effect – Mario Draghi agreed to re-double the ECB's bond buying programme by increasing it to EUR80bn a month, along with further decreases to interest rates. Yet this too was rejected by the markets, with the euro soon recovering to post a five-month high against the USD. 

The currency war that many speak of could benefit global macro players and CTAs, but there is so much uncertainty in the system that building high conviction positions in any asset is hard to justify.

A double dose of China volatility

Reflecting on 2015, Philippe Jabre, founder of Geneva-based Jabre Capital Partners says that the first six months were extraordinary but the second six months were challenging. 

"We kept on thinking that things would improve, that China would stimulate, that Europe would grow, that the oil price would recover, and every time we were proved wrong. We thought Europe would show good earnings growth and here we are, a year later with the EURO STOXX 50 Index down nearly 800 points. The Hang Seng Index is down 8,000 points compared to 10 months ago. 

"Everything basically moved the wrong way. It was a year of transition towards the negative but that should create exceptional opportunities in the medium term," comments Jabre.

Last year, China generated a double wave of volatility; first there was the collapse of the local market, as China's stock markets went into free fall, followed by a decision by the PBOC to let the RMB depreciate to boost exports. As if that weren't enough, on the 4th January, China experienced another market sell-off. This time, though, Jabre was prepared: "Since this was a similar script to August 2015, we quickly cut our net long exposure, we built up our short book and basically took measures to protect capital across all of our funds. We've been focused on China as well as the crude oil price. Earnings in Europe in recent weeks have not been good enough to satisfy market expectations. And now we are starting to see bank credit widening, which is another new impetus to declining markets."

The challenge of sideways markets

Miranda Ademaj is CEO and co-founder of Zurich-based Skënderbeg Alternative Investments. She notes that 2015 was particularly difficult because the stock markets essentially moved sideways for nine months. "We saw an 11 per cent decline in the markets and then a recovery of all those losses between August and October. It's very easy to get chopped to pieces in a market like this. The Skënderbeg Fund finished 2015 with a return (net of fees) of +2.5 per cent versus a return of -2.3 per cent for the HFRX Equity Hedge Index," comments Ademaj. 

The Skënderbeg Fund focuses on identifying equity long/short managers in the USD50-500mn range. Part of the reason it was able to generate a positive return last year is because the portfolio had a low correlation to global markets. There are numerous aspects to the strategy that are independent of market direction, which limits beta exposure. 

"Hence, 2015 was a solid year, especially when taking into account the low beta of the fund versus the market and versus our peers. Looking back on the year, there are two things in particular that are worth highlighting:

• Positive performance in each quarter.

• Strong result in the weak month of August when the MSCI ACWI plunged 7.0 per cent and Skënderbeg Fund rose by 0.8 per cent.

"In years like 2015, avoiding losses is at least as important as capturing market gains during positive years. This fact often gets lost in this performance-chasing environment. However, we feel that investors finally recognize the value of a strategy focused solely on the generation of alpha. We believe volatility will be considerably higher in 2016, which should be beneficial for the Skënderbeg Fund," explains Ademaj.

The case for market bulls

Over at Lombard Odier Investment Managers (`LOIM'), one of its 1798 Fundamental Strategies funds, LO Funds – Fundamental Equity Long / Short (`FELS'), had a very strong year, gaining 6 per cent. 

The fund is a US-focused vehicle that invests in five portfolio managers targeting Consumer, Healthcare, Industrials, Energy and TMT (Technology, Media, Telecom). Since inception in 2007, FELS has generated returns in line with the S&P 500 but with half the volatility and less than half the drawdown. 

"I allocate capital dynamically to a team of sector specialists who construct a balanced long/short portfolio within a defined set of risk limits. Our teams' research is based on fundamental equity analysis with a view toward industry dynamics and our strategy is highly diversified. We try to limit market correlations by conducting extensive factor analysis with our risk management group to ensure the portfolio is not sensitive to generic drivers like growth, price momentum or interest rates, to name just a few," comments Steven Bulko, CIO of 1798 Fundamental Strategies.

He says that while FELS is currently invested in all market sectors with the exception of financials, consumer discretionary and energy seem to have the most compelling outlook. 

"We view the consumer cycle as late stage with significant opportunity on both the long and short side, while energy is still dealing with a two-year decline in commodity prices that has broad-based implications across the entire sector. Additionally, mid-cap biotech companies have traded down to very attractive levels and should offer exceptional opportunities towards the back end of the year," adds Bulko. 

One of the consequences – intended or otherwise – of quantitative easing is that it forces investors to take more risk. According to Salman Ahmed, Chief Global Strategist at Lombard Odier Investment Managers, in a world of widespread disinflation and loose monetary policy, the bull case for buying risk assets is predicated on relative risk-premium (versus government bonds) and faith in central bank policy's continued positive impact on asset prices, if not on economic outcomes, both in advanced economies and China. 

"In China's case, the sharp rise in leverage in a number of domestic sectors (especially, local government, real estate and infrastructure) is evidently a huge issue. However, to offset this grim reality, appreciating that China has a command political and economic structure, with more than USD3tn in largely liquid reserves is important. In addition, the country has already seen outflows of around USD1tn over the last three years (according to IIF data), which implies that global exposure to China risks has reduced sharply.

"In addition to the China-based challenges, the bull case is further strengthened by a global disinflation environment (even in the US), which means other key central banks will have to deploy more monetary easing, as we've just seen with the ECB, thus re-activating the portfolio rebalancing channel, whereby investors will be forced to harvest the extra risk-premium on offer to meet their return objectives," argues Ahmed. 

In his view, the bull case is clearest in the European equity space, where the ongoing gradual economic recovery, easing credit conditions and deflationary environment is forcing the central bank to deploy more quantitative easing. 

Ademaj expects the differing sensitivity of specific equity sectors to interest rate movements to result in higher intra-stock and intra-sector dispersion. This should provide equity fund managers with more opportunities to outperform through stock selection. "While long-only and long-biased investments could experience difficulties if volatility picks up again, managers running with variable biases or market neutral approaches should be able to navigate the transition period better," suggests Ademaj. 

The situation looks a lot less rosy in Jabre's opinion, however, especially in the US. 

Consider industrial high yield spreads. In June 2014, they reached a low of 350 basis points above Libor. Today, they have risen to 873 basis points above Libor. The previous time this level was seen was in September 2011 when the US received a ratings downgrade, just before Bernanke introduced QE2. 

The inference here is that the Fed should have introduced the rate hike in June 2014, when spreads were half their current level, as opposed to waiting to December 2015, by which time the credit markets had tightened. 

"The only trades that are doing well in this current environment are volatility trades. We have some good volatility positions in the portfolio, and some good equity long/short positions – cyclical stocks are more affected by lower growth – and eventually yields will become interesting. Today, you can buy BBB-rated convertible bonds at 5 per cent in USD terms in an environment where inflation is close to 0.5 per cent. 

"But to be clear, we think there is still a lot of contamination in the market. First it was the falling oil price, now banks' credit spreads are widening. If you look at European banks a couple of years ago compared to now, their stock prices are down 65 per cent. There are fewer opportunities this year. China is too early to build any meaningful positions, there isn't much value right now in South Africa or Brazil. It's slim pickings at the moment," cautions Jabre, "but opportunities will emerge for sure as we are likely to see valuations exaggerate on the downside."

What would appear to not be in doubt is that among institutional investors, there is a growing acceptance that alternatives need to form an important part of their portfolio allocation. Market volatility is set to become far more the norm when central banks finally admit defeat and let the markets function without artificial support. Equities and bonds will mean revert, some even predict that US equities are due a 20 per cent correction in 2016. 

"There has been a growing interest in alternative solutions including many different strategies. In a couple of months' time, when markets have perhaps settled down, then we will have a clearer understanding of which hedge funds are adding value and which are not," says Michaël Malquarti, co-head of alternative investments at Syz Asset Management. 

One of the ways that SYZ Asset Management is supporting its investors is to provide solutions that tap straight in to the convergence taking place as both traditional long-only managers and hedge fund managers seek to adapt their product offerings. This resulted last year in SYZ Asset Management merging its alternative and long-only UCITS teams into a unified team. 

"Generally speaking, our allocation is 50 per cent to hedge funds, 25 per cent to long-only funds, and 25 per cent to alternative UCITS. The team only selects external managers to avoid conflicts of interest. 

"With respect to our FoHF core offering, we build the portfolio in such a way as to anticipate and deal with market volatility. Our two open-ended FoHF mandates were in positive territory in January for example. If you do things properly, you can construct portfolios that are robust and more or less correlated to durations or risky assets. We don't build portfolios in response to the current market conditions, we build portfolios to handle future periods of volatility," says Malquarti. 

From a sub-strategy perspective, he says that relative value strategies such as fixed income arbitrage and volatility arbitrage have the best opportunities to outperform in the current environment. 

"Now that there are more uncertainties on global economic growth, it is creating significant volatility and this is playing to the strengths of these strategies in particular. We have a large block invested in relative value strategies in some of our clients' portfolios, including equity market neutral strategies.

"Our focus over the next few months will be to find more global macro UCITS funds. It's difficult to find the right manager in this space. We will also look for relative value strategies, rather than the more plain vanilla strategies one finds in the alternative UCITS space," concludes Malquarti.

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