Tue, 12/11/2013 - 06:00
Sophie Chardon, head of quantitative and cross asset analysis at Natixis, looks at the key themes that dominated hedge fund directions in Q3 – and considers the impact on strategy.
There were three themes for hedge funds to consider in the third financial quarter of this year: the recurrence of positive economic news out of Europe, the rebound in market volatility due to uncertainty over the Fed’s monetary policy, and the capital outflows from emerging markets.
Yet despite the return of unpredictability, the industry held up well. Thanks to positive PMI results during the summer, European stock markets posted robust performances and risky assets from developed countries experienced a moderately optimistic quarter. In addition, US indices remain at record levels. For hedge funds, long/short strategies reported the best performance at +3.5 per cent, followed by event-driven strategies at +3.3 per cent. Meanwhile, commodity trading advisors (CTAs) showed the least well-rounded performance (excluding short sellers) with -3.9 per cent.
Of course, the storm brewing on the horizon concerns the viability of emerging countries – many of which have been hit by sluggish economic growth while sanctioned for external imbalances. Global economic challenges remain, and with these in mind, it’s worth looking at the overall trends of the hedge fund industry over the past few months, to see how various strategies have – or have not – paid off.
The Eurozone to the forefront
Against a backdrop of geopolitical tensions linked to Syria, political shuffles in Italy, and continued uncertainty over the Fed’s monetary policy, it was surprising that European equities posted fairly solid performances in the third financial quarter (+8.9 for the Stoxx600).
Beyond the favoured equity direction, the best performing hedge fund managers distinguished themselves through three approaches: an increased exposure to small caps on their quest for return; a greater emphasis on growth; and a reallocation to the European market. And certainly, these three bets proved worthwhile.
Contrary to the US, the European market hasn’t been particularly sensitive to liquidity since 2011. Reactions have instead been dominated by the macroeconomic news flow. Luckily, the economic consensus for Europe in the medium-term has vastly improved, which explains the recent cyclical improvement in the markets – particularly in an environment with reduced visibility on the Fed’s monetary policy.
Rebound in volatility in all markets
Certainly, we cannot go far in this analysis without drawing attention to the Fed’s remarks over the past few months – not least due to the volatility each announcement has caused. In fact, the third quarter was dominated by statements over the timing and practicality of the Fed’s ‘tapering’ of QE3, its quantitative easing programme.
Given the publication of relatively positive activity figures in the US, from manufacturing surveys, durable goods and retail sales – in addition to hawkish minutes from consecutive Federal Open Market Committee (FOMC) meetings – the market largely priced in the onset of a reduction of asset purchases from September.
FOMC minutes showed that all its members considered the slowdown in QE3 a given. Several members even seemed unfazed about the impacts of rising long-term interest rates on the economic recovery (as they expected such a trend would go hand-in-hand with improved growth).
And so – although August was particularly volatile for bonds and equities – it still came as a shock that the Fed chose to delay the taper in September, even if the action proved to be timely in the view of October’s political deadlocks over the US budget and debt ceiling.
A bull market in equities and bonds subsequently accompanied the immediate fall in volatilities. And, as expected, this environment proved positive for arbitrage strategies, which ended the quarter in positive territory.
For those choosing equity market neutral strategies, the amount of exposure to style factors separated the winners from the losers. The best hedge fund performers reduced their equity directional and maintained significant overexposure to small caps and growth stocks in the US market. But with performances ranging between -2 per cent and +6.8 per cent, significant dispersion remains. This underlines the range of equity beta implemented by these managers and the consequent risk characteristics marking this strategic direction.
Meanwhile, the bulk of convertible arbitrage strategies (+0.9 per cent) saw success. This is largely thanks to their exposure to Japanese equities –despite an increase in instability and a fall in stock markets that indicates high coverage ratios.
As further proof of the consensus for tapering, the majority of fixed-income arbitrage (FI Arb) managers had – to some extent – reduced the duration of their portfolios (and increased their exposure to HY credit), which limited the impact of a continued rise of interest rates. Looking back, the best performers have been those managers able to boast the highest overall exposure.
In foreign currencies, carry strategies underperformed (on the whole) due to rising volatility, while the long dollar bias against the euro –once again implemented in preparation for incipient tapering – negatively affected all funds
Emerging markets in the eye of the storm
The tapering debate – and expectations around it – has significantly impacted emerging markets. The amount of foreign capital in the region has shrunk significantly since July – momentarily for stock markets and more lastingly in the bond market for the full quarter. And this has led to steep exchange-rate depreciation, especially in India and Indonesia.
In addition to the tapering effect and, implicitly, capital returning to domestic markets, this ‘drying up’ of capital flows has renewed doubt over the ability of several emerging country governments to solve their structural problems.
Although the positive momentum of the stock markets has – on the whole – benefited emerging funds, significant disparities exist between the best and worst performers, and this gap reflects the diversity of managers’ bets. Those with the upper-hand reduced their exposure to US equities in favour of emerging equities, and put more emphasis on European stock markets (+4.7 per cent for the S&P500 and +12.7 per cent for the emerging EU in Q3).
In the bond market – affected by the capital outflows on a larger scale than equities – the best performers reduced the duration of the US segment and their exposure to emerging markets. All in all, the top players recorded a performance of +10 per cent in the quarter while lesser performers posted -6 per cent.
Certainly, the hedge fund industry benefited as a whole from the rebound of emerging market assets in September (+5 per cent for equities in the quarter), as the trend limited the potential losses felt during stress periods.
The lack of overall trends hurts directional strategies
Directional strategies, however, continue to suffer from the rise in interest rates and the uncertainties surrounding the end of expansionary US monetary policy.
All the same, global macro strategies managed to end the quarter in positive territory (+0.2 per cent in Q3), underpinned by exposures to corporate assets (HY/equities). The best performers increased their exposure to the stock and commodity markets, a move that paid off as oil rebounded by +6.4 per cent in Q3 after the resurgence of tensions in the Middle East, vs. +8.6 per cent and +4.4 per cent for precious and industrial metals.
As already mentioned, CTAs showed the least well-rounded performance in Q3 (excluding short sellers) with -3.9 per cent, hurt badly for their geographical preference for US equities (long) at the expense of European equities (short) as well as their exposure to carry strategies.
Conclusion and recommendations
Following the decisions made at September’s FOMC meeting in the US – and especially after the government shutdown and political deadlock in October – Natixis’s US economists now believe that the timing of tapering will be announced in January. Our interest rate scenario is therefore delayed by a few months, but we still believe in a gradual normalisation of long-term interest rates in 2014, favouring a rotation into risky assets. In the shorter term, the uncertainties surrounding the quality of the global recovery are likely to give rise to new episodes of volatility.
Therefore, until the end of this year, we are largely repeating our recommendations from last quarter. These include the overweighting of arbitrage strategies and gradual reweighting of long equity bias strategies. And while directional managers will continue to suffer from a certain lack of trend, the selection of managers will prove crucial.
Lastly, we are returning to neutral on emerging markets. Despite a relatively pessimistic outlook for this area as a whole, certain managers should be able to generate alpha by discriminating between assets/countries. Here again, fund picking is crucial.
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