Hedge fund update from the GAM AIS Investment Committee
11 January 2018
Alternative industry trends
As we begin 2018, global asset prices have continued their inexorable grind higher. There is increasing unease from investors on the length and extent of the current rally, whilst central banks are increasingly on a rate tightening trajectory. As a result, interest in strategies that can hedge against any sell-off in risk assets are growing. At the same time, investors are more conscious of the level of fees they are paying across the asset management universe, due in part to a greater awareness of benchmark hugging and a growth in the popularity of low cost passive strategies. Similarly, developments in factor theory and fund attribution have increased transparency on the sources of return, leading investors to be reluctant to pay for strategies that can be accessed through simpler implementation methods, but also willing to pay where they see demonstrable alpha.
Given these market trends, we have seen growing interest in blended approaches to alternatives such as combining alternative risk premia (ARP) with higher alpha hedge fund strategies. The result is a flexible solution that can easily be adjusted to account for individual investor preferences on fees, volatility / return targets, liquidity requirements or the need for additional customisation such as completion portfolios.
At the more liquid end of the spectrum, there has been a significant increase in market interest in, and capital allocated to, ARP. These products access alternative premia, including through styles such as value, momentum and carry, which offers a non-correlated return profile to market beta. Returns to individual premia and managers in the space have been extremely dispersed, reflecting the wide range of ideas and implementation methodology available. However, the rules-based, transparent processes mean the product is broadly available at an attractive fee relative to traditional hedge funds.
However, ARP does not offer a complete solution, given some structural limitations which allow hedge fund strategies to generate alpha in addition to that available through style or market structure premia. These include strategy or operational complexity, leverage, illiquidity, concentration and inability to recognise macro regime change. We believe this is where investors should focus their fee budget within the hedge fund universe, in addition to a basic allocation to ARP and liquid hedge premia.
Our 2018 outlook for accessing opportunities within pure hedge fund strategies is showing in Table 1.
The views expressed are those of the manager at the time of publication and are subject to change. Allocations and holdings are subject to change.
We continue to underweight traditional long short managers whose net exposure has remained relatively static over market cycles. In our view, investors pay too much for market exposure and can find more efficient alternatives to equity beta. 2017 saw an improvement in the peer group’s performance but if developed equity markets become range-bound, fund returns are likely to disappoint. In contrast, if we see market rotation or increased dispersion of single stock returns, we would move towards an overweight position in equity market neutral strategies. At the regional level, we have a slight bias to international versus US opportunities.
Emerging markets have had an extremely strong run but we remain positive on the opportunities available to specialist discretionary macro managers. The differing growth outlooks and divergent micro level drivers are notable, with idiosyncratic events such as political elections, local interest rate cycles and debt restructuring such as in Venezuela providing good opportunities in debt and FX spaces.
In the systematic space, we believe quantitative managers can continue to offer differentiated return profiles through innovative techniques for identifying patterns across markets, such as utilising machine learning approaches. Similarly, although recent market dynamics have produced softer returns in the shorter-term trading space, we expect that the potential for more dispersion in the larger-cap space and at the index level could lead to an uptick in opportunities in 2018.
Figure 1 shows the headwinds short-term managers faced, with the SG Short Term Trader Index in blue down sharply in early 2017 due to low volatility (VIX) in red and very narrow daily trading ranges (shorter wicks on the SPX candlestick chart):
For longer-term trend programmes the standard approach is crowded and as a result has generated returns below expectations in the past few years. For both short- and long-term strategies, their long volatility characteristics have been a hindrance and so if we start to see uncertainty being repriced back into assets then both short-term and longer-term models should recapture some of their attractive historic risk adjusted returns. One area that we believe will provide attractive returns for 2018 is the harder to access exotic asset markets. A number of CTA managers have launched products in this area and are quick to close their funds to new money due to levels of underlying liquidity. A note of caution, however, is that the growing number of new entrants could lead to crowding.
2017 was a disappointing year for many event-driven strategies despite initial optimism. While spreads were relatively attractive, the investing environment was incredibly challenging. Specifically, spread volatility was unexpectedly high in many popular transactions as shareholder opposition, anti-trust concerns and political issues led to deal delays. Nevertheless, we consider the overall thesis for the strategy to be positive, but continue to favour short term special situations that are difficult for more rules orientated approaches to replicate. These include investments in less followed markets, such as corporate activity in Asia via rights issues, deleveraging of balance sheets and asset disposals.
In our view, fixed income micro rates remain an important area for potential outsized returns. Although there has been increased capital allocated to the space, which has led to some compression in dislocations, we believe the on-going opportunity set is still attractive. Any pickup in rates related volatility, potentially from central bank tightening, would be beneficial for the strategy. This strategy, if executed correctly, also provides protection against rising interest rates which is valuable to any investor with an overweight in debt securities, such as pension or insurance companies. Other more niche relative value opportunities within fixed income include convertible arbitrage and mortgage arbitrage.
In the convertibles space, the higher degree of security complexity and reduction in the number of sophisticated investors creates opportunities to structure trades with attractive pay-offs. In allocating to such opportunities, we believe an emphasis should be placed on managers with strong credit analysis capabilities in order to protect from any potential market weakness. Within the mortgage space, the impact of rising interest rates on mortgage rates could create dislocations in a market that has been awash with central bank induced liquidity since the global financial crisis.
Source: GAM unless otherwise stated.
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