Equity markets have merely sneezed in response to the coronavirus (Covid-19) and while there is uncertainty over how much fear has been priced in, as infection numbers continue to rise, hedge funds have navigated developments with discipline and a modest reduction in net long exposure. For now, rather than trying to react to short-term moves, managers are taking a prosaic stance.
Equity markets have merely sneezed in response to the coronavirus (Covid-19) and while there is uncertainty over how much fear has been priced in, as infection numbers continue to rise, hedge funds have navigated developments with discipline and a modest reduction in net long exposure. For now, rather than trying to react to short-term moves, managers are taking a prosaic stance.
The first reported case of Covid-19 in Wuhan broke on 31 December 2019. Over the days the numbers grew and the markets reacted with trepidation but it was nothing more than a sneeze. No sooner had the Dow Jones Industrial Average fallen through the second half of January, it had fully rebounded through mid-February.
There is no denying that China’s Q1 GDP figures will be hit hard by this outbreak. This is already having an impact on shipping, with the Telegraph reporting today that Europe faces “a logistical crunch” in early March. US technology groups with huge exposure to China have incurred losses this week, led by Intel Corp, Microsoft and Apple. If reported cases in the West continue to rise, markets could retreat once again.
Speaking with Hedgeweek, one New York hedge fund group which focuses on emerging market opportunities says: “Europe is one of the least attractive areas for us because EU countries are exposed on exports and there is little chance of fiscal stimulus being used to offset some of that supply shock (from China).”
In Europe, equity long/short managers are taking a ‘wait and see’ approach to avoid getting caught up in unwanted volatility moves.
“Long/short equity managers have not reacted to these macro developments, other than to add a layer of risk reduction. They remain largely unchanged on their outlook,” says Philippe Ferreira, senior Cross Asset Strategist at Lyxor Asset Management.
He confirms that net leverage fell moderately for equity long/short funds over the course of January, from 48 per cent to 44 per cent for US strategies, while in Europe and Asia “the adjustment was even lighter”.
“The market is very erratic on news,” says Phillip Chapple, Chief Operating Officer and Chief Compliance Officer, Monterone Partners, which runs a concentrated portfolio of European equities. “There were a few days when the markets fell heavily but since early February they have largely bounced back. I wonder if the market has become slightly immune to such major market news? The Trump impeachment, the coronavirus, Middle East tensions – I think if this were five years ago, the effects may have been larger and longer term.
“There’s always a major news development and for us, it creates potential entry points when markets have these short-term corrections but we are not trying to trade around macro developments. We are more longer term.”
This health outbreak has been revealing in the sense that major macro news appears to have dented market sentiment briefly, and is yet another example – like December 2018 – of a short volatility jump event that fails to break out into another longer or more substantial. It is almost as if with so much news dominating our lives today, our collective fear threshold is rising.
“We think this health impact is temporary. Our view is this should be a pretty good year from emerging market equities and local currency debt. Some of this started to play out last year and would continue into 2020 until the outbreak happened. For now, it’s a case of staying patient to identify the right buying opportunities,” explains the US manager.
They see further upside potential in Chinese equities if the government injects fiscal stimulus, “which we think they will”.
Ferreira observes that managers are in ‘wait and see’ mode as opposed to seeking out fully-fledged downside protection and says that hedge funds were quite resilient in the latest stress tests:
“Credit long/short managers outperformed in January despite the small market correction. CTAs were doing very well but lost some of their gains; they were up 2.2 per cent through mid-January and ended the month up 0.6 per cent.
“Macro was slightly down in January but emerging markets-focused macro strategies were very resilient,” he comments.
Part of this resiliency is down to EM-focused macro managers investing more in EM debt than equities.
Credit spreads did widen but given that EM debt markets are more Latin America-orientated than EM equities, which are weighted more towards China – which accounts for more than 30 per cent of the MSCI EM Index – the impact of the coronavirus has been much more limited.
“We don’t think now is the right moment to ramp up our risk,” says the US manager. “On the question of what to buy I would point to two themes in which we see the best opportunities: firstly, countries with larger domestic demand; we still think Chinese equities are worth looking at. And secondly, countries with the flexibility to offer fiscal stimulus.”
At a time when hedge funds continue to draw criticism for the value they supposedly bring to investors’ portfolios, events over the last six weeks (and indeed towards the end of 2019) serve to illustrate a key point to this asset class. They make no bones of trying to outperform a 30 per cent gain in the S&P 500. Alpha opportunities are always the priority but equally, so is reducing drawdowns in the portfolio and preserving capital.
The energy sector is a case in point. Both the lethal drone strike on General Qassem Suleimani and coronavirus outbreak have hit oil prices hard: down 25 per cent for the year through the end of January.
“When we look at sector exposure among equity l/s managers, they had been slightly short energy for a while, in advance of the virus outbreak. They’ve avoided incurring losses in this area of the market,” states Ferreira.
Before the coronavirus outbreak happened he says there was definitely a sign that managers were putting more risk on the table. “Some l/s equity managers were quite cautious by the middle of last year but they saw the markets rally again in late August and through the course of Q4 they increased risk in their portfolios. This continued up until mid-January, when the coronavirus outbreak was first reported.”
Taking risk off the table, even modestly, is precisely what any good hedge fund should be doing when it is unclear what the overall impact of an event like coronavirus could have on the market. Even if it means leaving a bit of upside on the table. Else, a double-digit annualized return could easily fall into negative territory. Maintaining investment discipline comes to the fore in times like these.
“These health outbreaks are terrible but we have to consider how it impacts the companies in our portfolio by removing the element of fear and assessing what is the real impact and model it out.
“It’s best not jump either way and to take your time, and hold your discipline. You’ve got to have a longer term view; and that applies to our shorts as well as our longs. It’s too easy to get short-term trading wrong in this market,” concludes Chapple.
