James Williams, Hedgeweek

Expect more volatility in 2019


The ability to deliver compelling alpha to hedge fund investors gets ever harder but those who bring a disciplined, resilient approach to their investment strategies, and stick to their convictions, stand out from the crowd. And what a crowd it is, with more than 10,000 hedge funds in the marketplace. 

With more data and analytical tools available to investors, they have more capacity than ever before to interrogate their investments and determine exactly how, and to what extent, hedge fund managers are delivering a true source of alpha. Those who do can expect to curry favour with investors, who despite a challenging few years, performance-wise, continue to hold faith with the asset class. 

As Preqin found, nearly 80 per cent of institutional investors they surveyed plan to maintain or increase their allocation to hedge funds in 2019. Nearly one third (29 per cent) of those investors said that they would look to increase their exposure to macro strategies, perhaps signalling concerns over the geopolitical landscape in 2019 and a potential market correction as a result of slowing global GDP growth. 

Last year saw hedge fund total AUM reach a new record high of USD3.62 trillion, with investors flocking to credit strategies in particular, attracting USD22 billion in net new inflows; up 12 per cent on 2017. 

It’ll be interesting to see how the interest rate environment and greater market volatility influences the way investors allocate to different hedge fund strategies over the next 12 months.

Offering his view on a rising rate environment, Jean-Francois Comte, CIO of Lutetia Capital – winner of this year’s Best Relative Value Arbitrage Hedge Fund – which operates the Lutetia Merger Arbitrage Fund, says: “Risk-free rates are naturally reflected in arbitrage spreads, as we get paid for the duration of the deal in addition to the ‘risk premium’. Higher rates will therefore help produce higher returns in merger arbitrage. To be fair though, returns should be looked at net of the risk-free rates in any strategy – on a relative basis,” says Comte. 

As we approach the end of the first quarter of 2019, global political and economic developments point to a new volatility regime for markets, reinforced by the fact that across all asset classes, markets continue to display signs of incredible fragility. As we are all aware, this past December marked the worst S&P 500 performance since 1930.

Commenting on this, Hudson Bay Capital, winner of this year’s Best Convertible Arbitrage Hedge Fund, said it believes volatility will continue in 2019 and that opportunities will emerge from structurally higher volatility combined with ineffectual policy makers. “In our view, volatility drives opportunities for alpha players, and we are excited about the opportunities on the horizon,” said the Hudson Bay team in New York. 

At the heart of any good hedge fund is a robust risk management framework. Again, if volatility spikes this year, the need to react quickly and optimise position sizing in one’s portfolio will be key. Hudson Bay uses a unique approach which it calls the Deal Code Portfolio Construction

Process that allows the team to granularly manage and monitor potential downside risks in the portfolio.

“We evaluate our investment ideas at the position (or Deal Code) level,” the team explains. “Neutralising beta at the position level simplifies portfolio management and, in our opinion, enables the portfolio to benefit from the power of diversification. Risk guidelines set at the Deal Code level foster the construction of a portfolio of independent, diversified trades with limited downside. 

“We also utilise RMon, a proprietary risk monitoring system, to facilitate daily monitoring of portfolio diversification through our patented statistical measure, the Gerber Statistic.

“We created this system in response to our concern that the common measures for diversification, such as correlation and covariance, have not kept pace with the increasing complexity and dynamism of financial markets.”

Metori Capital Management – winner of this year’s Best Systematic CTA – operates out of Paris with over USD390 million in AUM and runs the Epsilon Funds programme. 

Epsilon trades liquid instruments through organised markets, in all major asset classes and regions. 

Picking up on the diversification point made above, the Metori Capital team explain that to achieve true diversification, they consider cross-asset dependencies and undertake a global statistical analysis. 

“Markets that are highly correlated (either positively or negatively) are typically driven by the same market factors,” says Guillaume Jamet, Principal Manager and Co-CIO. “This means that the actual diversification of a given portfolio does not depend on the number of markets in which it is invested but depends on the actual number of independent factors to which it is exposed.

“The level of diversification is dynamic and depends on market conditions. It must be accounted for in the design of the allocation model.”

One key aspect to hedge funds attracting more institutional dollars in 2019, alongside performance, will be clearly articulating the investment strategy and how it fits into an investor’s wider portfolio. This might sound obvious but there is still confusion over how strategies work and what their merits are. 

At Lutetia Capital, they make a point of emphasising that theirs is a “pure” merger arbitrage strategy, as opposed to strategies that mix merger arbitrage and event driven situations. 

Technically, they belong to the same category, but one is a naturally uncorrelated yield strategy, while the other (event driven / special situations) tends to be highly correlated to the market and does not provide the same visibility on returns. 

“Keeping the strategy purely merger arbitrage allows us to quantify everything from the portfolio’s performance reserve, to its duration, and its expected return. These elements can be discussed with investors with a high level of transparency. It is the opposite of a “blank check” strategy,” remarks Comte. 

Looking ahead, the Metori Capital team point out that because markets remain driven by multiple strong themes – ongoing trade tensions, central bank policies, Brexit, economic outlooks in all regions – this will provide a large opportunity set for trends emergence.

At the start of the year, says Jamet, the Epsilon model was mostly out of equity markets and US fixed income. The main positions were (and remain today) long USD and long European and Japanese bonds. 

“Epsilon progressively re-built a long equity exposure over the first two months in Canada, Australia and selectively in Europe, while mostly staying away from China, Japan and teh US. But the overall long equity exposure remains prudent, which is a sign that it is still a high-risk area.

“YTD performance is back to positive but the true trends are yet to come. Timing an investment in CTAs based on recent performance is a very hazardous business. Trend-following on trend-following does not work. To earn the time-series momentum risk premia over the long term, investors must get through the tough periods, and be patient,” concludes Jamet.

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