The Lyxor Hedge Fund Index was down 2.3 per cent in October (YTD -1.4 per cent) with just three out of 12 Lyxor Indices ending the month in positive territory.
The Lyxor CTA Short Term Index (+1.7 per cent), the Lyxor Long Short Equity Market Neutral Index (+0.4 per cent) and the Lyxor CTA Long Term Index (+0.1 per cent).
Sentiment deteriorated rapidly as a marginal shift in the fragile balance between US reflationary dynamic and Eurozone deflationary forces raised doubts about global growth prospects. Moreover, the USD appreciation started to be considered as a growing threat for US activity. The unfolding of a virtuous reflationary cycle for the world economy seemed to have become less likely, which prompted investors to reposition portfolios. While a majority of strategies suffered, event driven funds were by far the main victims of the sudden flight to quality and liquidity. In contrast, CTAs were the main beneficiaries from the acceleration of the correction and the domino of themes gradually expressed over the month.
L/S equity funds’ returns were unsurprisingly hit on their beta exposures but they were able to generate alpha. Sectors and stocks related to global resources and global trade and export were hammered during the correction. Meanwhile, sectors sensitive to rates or domestic market driven were re-rated. Such differentiation offered tradable themes, which was reflected in portfolios. Gross and net exposures were only marginally shaved off over the period, but shifts at a sector level were more notable, out of energy into financials and consumer discretionary. The earning season was another source of alpha generation in the second part of the month. While shrugged-off during the correction, stronger pricing differentiation then emerged. In the US, companies beating estimates usually outperformed; in Europe the start of the season was decent considering the economic deceleration over the quarter. Along with earnings, the return of dispersion contributed to improve the alpha backdrop. Funds with limited market bias outperformed over the month.
Event driven funds endured a severe hit in October on a combination of adverse developments. The dispersion of returns was also very significant, with four funds losing more than 6 per cent. The Merger Arbitrage funds were the worst performers. Widely considered as a remote risk two months ago, tax inversion ruling and the break-up of the Abbvie/Shire operation reverberated to the whole merger arbitrage space. Helped by rising risk aversion and amplified by the heavy concentration on a handful of deals offering decent profitability, most spreads widened simultaneously.
Embedded liquidity risk in special situation painfully materialised in October. High yield and distressed credit, small caps and long term situations (including activist and private equity positions) got sold out. This was amplified is those markets segments lacking market depth and with weak holding diversification.
Special situation funds also took another hit from their exposure to the global resources and energy sectors, which collapsed during the correction. Net exposure to the basic material sector was left unchanged unlike the allocation to the energy sector, reduced during the month. Additionally, several companies which had faced adverse idiosyncratic developments in September, got further sanctioned. These include the Athabasca Oil, Anglogold, Hertz situations. Finally, few funds were hit by the unexpected Fannie Mae and Freddie Mac ruling, allowing the US Treasury to collect most of the profits achieved in these two agencies following their 2012 bailout. Event driven funds have partially benefited the rally as pressure on inversion deals, illiquids and resources persisted. US funds were particularly exposed to these developments. In contrast European and Asian funds fared better.
Credit markets were also under heat during the correction. Signs of further deterioration in European economy triggered an even sharper HY widening than in the US. In that context, L/S credit funds proved resilient. They had maintained cautious net exposures. Some managers also benefited from favourable developments in their Argentine and Venezuelan exposures. Convertible arbitrage only marginally outperformed their credit peers. The lesser liquidity in their market segment was more aggressively priced in the first part of the month, and mutual funds redemptions accelerated. This was particularly perceptible in the US market. However the rally was steeper.
CTAs didn’t disappoint as diversifiers during volatility spikes. ST CTAs outperformed their LT peers. The reversal of the USD uptrend and long exposure to equities were a drag on the performance of LT models. Performances were also a mixed bag by mid-month as the relief rally triggered multiple repositioning. Losses were partially offset by their long bond exposures and short commodities allocation, both reinforced in October. By month-end LT models had cut all of their equity exposure; they are long USD crosses and bonds, they are short commodities. Short term models were best fit to navigate the turn in the dollar and the mid-month reversal.
The bulk of the global macro funds’ drawdown occurred in the second week. They were hit by long resources and energy exposures, and to a lesser extent on their long USD crosses. They benefited the equity rally though their allocation to bonds and yield curve produced mixed returns.
“While the recovery dynamic should prevail, disinflation and reflation trends keep markets at a pivotal point. We opt for a more contrarian positioning and reinforced risk management,” says Jean-Baptiste Berthon, senior cross asset strategist at Lyxor AM.
