One of the prevailing thoughts among the hedge fund community at this year’s Hedgeweek USA awards in New York, which took place on 20 September, was the expectation that volatility was steadily making a comeback.
As many will know, volatile markets are a hedge fund manager’s best friend. Like big wave surfers in the middle of a storm surge, they thrive on the adrenaline of choppy markets and big price moves. But as we observe (or perhaps lament) the 10th anniversary of the Global Financial Crisis, one of the defining characteristics of that period, broadly speaking, has been a perniciously low volatility environment.
This has proven exasperating for hedge funders. Constant central bank intervention through QE and asset buy-back programmes to support Western economies has driven interest rates to historic lows and given rise to the strongest US equity bull market since the Second World War.
The effect of this has been to create a false reality, a Platonic Simulacrum, with equity markets vastly overpriced relative to the underlying fundamentals of the economy.
But there are signs that this extended period of low volatility could be ending. The US Federal Open Market Committee increased the fed funds rate 25 basis points to 2.25 per cent at the end of September, with US GDP growth forecast to hit 3.1 per cent by end of 2018.
As markets return to fundamentals, this should provide hedge funds with more opportunities to seek out idiosyncratic sources of alpha, and in turn potentially provide outsized returns for their investors. If Ray Dalio’s prediction that we are in the seventh innings and the next market downturn – which will likely be a slow grind – could be just a couple of years away, the level of fear, and therefore volatility, in the markets will likely tick upwards.
This will particularly suit quantitative hedge funds that use sophisticated machine learning algorithms to gain an information edge in the marketplace. When markets become volatile and chaotic, to the casual observer things look very random. In reality, these periods are much more predictable.
“A properly tuned machine learning programme can predict what the next few moves are likely to be (i.e. over the short-term) after the butterfly flaps its wings,” says George Sokoloff, co-founder of Carmot Capital. “In the brief periods when markets have been stressed, such as in 2015 and 2018, Carmot has shown itself to excel and generate some nice returns. Were we to have more of these volatility periods going forward, Carmot is designed to deliver strong performance.”
The VIX index is approximately 20 to 30 per cent higher than last year. It has been range-bound between 12 and 13 since May, having spiked at 31 in February. This event, dubbed the “Volpacalypse”, saw the S&P 500 experience a 10.7 per cent decline in just six trading days.
Michael Spelman is CIO at Optima Fund Management, one of the industry’s oldest and most revered FoHF managers. Reflecting on the market conditions in 2018, and based on Optima’s three core themes of Policy Regime Change, Economic Reflation, and anticipated Asset Rotation, Spelman says: “We see 2018 as a harbinger of a more ‘normal’ environment where stock and bond performance could be more volatile, but nevertheless driven by fundamental merit rather than by loose monetary policy.
“This implies that in contrast to the past 10 years, the opportunity set for active management going forward should be very positive based on a simple and empirically strong observation: Alpha “likes” fundamentally-driven performance, especially when it results in higher volatility and higher dispersion of returns. Based on our research, we expect to see more of this going forward both across and within asset classes.”
Regarding its portfolios, Optima is playing an “offensive and defensive game” on the ground while also making sure that it maintains high-level situational awareness.
Within equities, Spelman confirms that it maintains healthy allocations to growth-oriented sectors such as Tech and Cyclicals, “as we believe they offer some of the best sources of return in the latter part of a macro cycle. At the same time, we are boosting exposure to alpha-rich diversifiers including quantitative, market neutral, and country specialists.”
Within the macro space, the interest rate and currency managers that Optima allocates to continue to maintain a short-duration bias overall. It also maintains exposure to specialists in emerging markets, commodities and volatility trading.
One of the symptoms of the low rate environment is that the markets have been highly receptive to companies issuing debt with few covenants, if any as investors waive rights to seek out extra yield. These covenant-lite deals have allowed companies to refinance debt with ease. This loose level of lending has gotten some industry commentators worried that an accident is waiting to happen.
The Bank for International Settlements warned that likely distress among indebted borrowers may spread into the wider economy as central banks raise interest rates. Their fear is not the level debt but the fact that investors seem less concerned about protecting themselves against losses, the BIS said. For context, the total of leveraged loans and high-yield bonds outstanding in Europe and the US has doubled to about USD2.65 trillion since the financial crisis, according to the BIS.
“I think there are certain sectors including retail in which companies continue to struggle, such as those that were taken private five or six years ago that are levered and really don’t have the flexibility to change their strategy,” says Neil Weiner of Foxhill Capital Partners, an event-driven hedge fund that focuses on distressed and special situations in the US mid-market.
“We’ve seen individual names and companies facing specific problems. Industry-wide, I think US retail is oversized. A lot of debt has been issued with no covenants so investors are not going to have many rights as companies enter distressed and stressed situations. They will effectively operate as ‘zombie companies’ because investors won’t have the legal ability to restructure them because of fewer rights,” says Weiner, who adds:
“There’s a tremendous demand for private credit; hedge funds and PE funds are underwriting their own deals. This is pushing prices down and it’s becoming riskier and riskier. Unlike debt in the capital markets, which tends to be syndicated, these are bilateral arrangements. If companies get into trouble, there’ll be no liquidity. The big question mark is: What will happen to all this debt that is being issued as private credit?”
If and when volatile trends upwards, active risk management will come to the fore and allow hedge funds to demonstrate their value to investors, some of whom have become distracted with low-cost passive funds in recent years.
Sancus Capital Management is a credit manager that specialises in investing in complexity premiums through structured products, such as CLOs and synthetic tranches. The founder, Olga Chernova, says that risk management is a key part of portfolio construction.
“We start by identifying trading opportunities with limited or asymmetric downside potential. Each trade is assessed independently and via its contribution to internal stress tests. Position stop losses are established before entering each trade and concentration limits are checked. Our approach to risk management is very transparent: internal system generates risk reports overnight which are available for review by everyone in the Fund,” explains Chernova.
She says that in 2018, the CLO market has been dominated by three big themes: 1) A repeal of the risk retention rule; 2) A huge refinancing wave and 3) An increase in equity-friendly structural features.
The repeal of the risk retention rule generated a lot of supply in CLOs, which led to a widening in spreads of CLO liabilities. CLO managers no longer have to post 5 per cent of the transaction capital from their management companies or risk retention funds.
The repeal of this onerous capital requirement allows existing managers to issue more deals, as well as attract multiple new entrants into the CLO management space.
In addition, 2018 has seen a huge volume of the refinancing transactions.
“Most of the 2016 vintage is callable now and the tranches are ‘in the money’ to investors as the last two years saw a large spread tightening. Equity holders have a big incentive to refinance. This refinancing wave has been adding to the new transaction volume causing oversupply in the market and driving CLO liability spreads wider compared to the start of the year. In response to this, equity investors have been trying to defend arbitrage by introducing structural features, giving CLO equity investors more optionality.
“Despite the recent tilt in CLO market towards debt investors, we view CLO equity as very attractive long-term. If investors share our view that the current credit cycle expansion is nearing its end, it is an opportunity to lock in tight spreads on funding long-term CLO liabilities. If credit markets widen, equity in new deals with long reinvestment periods will do very well,” says Chernova.
Quant, event-driven and credit long/short, not to mention equity long/short and global macro hedge fund strategies, will likely all benefit as the volatility regime improves.
As markets return to fundamentals and asset class decorrelations improve, the next two years could be a good period for alpha hunters, large and small. n
