20/20 foresight for hedge funds in 2020?
By Jim Neumann, Sussex Partners – As the New Year is now almost upon us, it is normal to take pause and consider what is to become of hedge fund allocations in 2020. The rewards of 2019 again seem to pale in comparison to the robust global equity markets roaring at 20 per cent including a robust November (December?).
The pendulum of passive versus active remains in motion with the equity market rally easing it towards passive once again.
However, the “smart money” ranging from corporate pensions, to family offices, to private banks are continuing to buy into the premise that markets will be less certain as the calendar turns and thus active needs to be (re-)inserted to provide some downside portfolio protection/opportunity capture. Hedge funds are at the forefront of active portfolios and the dual dilemma is will they perform a needed role in 2020 and what strategies should be favoured?
Critical to planning for the year(s) ahead is a careful dissection of current positioning, which varies greatly even amongst similar investor types. However even with a myriad of differing portfolio approaches, two real problematic commonalities bubble up from all institutional investor types - the reliance upon equities as a return driver (public or private) and the lack of yield in fixed income to provide stability. Each one of these should elicit concern, but combined, a conundrum, which seems to lack a solution in the long-only realm, is highlighted. Without entering into more complex solutions, long/short exposures (usually in hedge fund format) would seem one of the few options to position for less certain markets.
The risk to shifting out of what has been working, most risk assets with equities featured, is the opportunity cost of being early and thus foregoing gains should the rally continue. Less liquid investments like private equity or private credit may not be available to fund new long/short investments, but investors should be able to redirect some long equity or perhaps better yet, long fixed income exposures to the alternatives bucket. Determining specifically which strategies will function the best for the portfolio is a crucial decision, but should be decided with return, correlation, and upside convexity in the equation.
For those seeking a turnkey solution, it is worth investigating the few defensively designed multi-manager products which aim to offer a reasonable return in status-quo market environments, but which offer significant upside and hence protection in more dislocated scenarios. As outlined previously, strategies such as global macro, managed futures, volatility, and commodity arbitrage might fit well. For those that have the resources to build more bespoke exposures to complement the core portfolio, there are strategies that seem opportunistic, but there are those flashing danger signs as well.
20/20 2020 Picks & Pans:
Top Picks: Diversifying, Uncorrelated Strategies
Top Pans: Directional Equity or Leverage-Reliant Strategies
Picks: The basket approach is favored here with a mix of uncorrelated strategies. It has been a bit surprising to hear the negative outlook on global macro from other industry participants at some recent forums, as both discretionary and systematic macro seem to be lining up to continue their newfound performance. The focus in global macro has been on blending styles as well as geographies.
The upward march of equity markets seems to have resulted in the volatility short-sellers getting increasingly bold, particularly in Asia. This global subdued volatility in not just equities but fixed income, currencies, and commodities, only makes a sophisticated exposure here more attractive. This is particularly true against the full to stretched market valuations and the complex geo-political backdrop. Given that Asia has been a hotbed for structured note issuance which is accompanied by issuers having to sell volatility cheaply, this region is a good place to begin sourcing managers.
Away from the liquid diversifying strategies which have been a focus for a year, some manager-sourced idiosyncratic event and more distressed exposures are seeming more timely. The problem with waiting to allocate to distressed until the cycle is clear and actionable is that capital may be scarce. Therefore, investing some portion of an eventual budget will ensure some level of participation in the initial, non-picked over stage of the cycle. Event driven strategies that require tangible manager infrastructure and expertise to harvest alpha can also provide some uncorrelated returns designed to be persistent no matter if the equity markets begin to fade or not. Allocators do however need to be wary of getting into illiquid positions without a clear exit or at least a strong control position to drive to the desired outcome.
Pans: Okay perhaps directional equity driven is a bit too broad a stroke and certainly all can recognize the power of equities to enhance a return stream. If shifting from long-only equity into equity long/short, a tight net is favored (+/-25 per cent) for the upcoming period. Also favored are sector specialists, not too narrow, and geography specific funds where fundamentals may continue to hold sway. Here Japan remains a favorite as do TMT and Healthcare given their broad scope and dynamic state. The excitement about China opening up is worth noting, although the prudent investor might access via local multi-manager platforms rather than directly given the vagaries, such as rule of law. As liquidity can be fleeting given the structural changes to the market, strategies that rely upon leverage and liquidity from third parties are to be avoided under the start of a new cycle where a re-pricing will make execution less important.
As 2020 is now firmly in the windshield, investors need to assess their portfolios with an acknowledgement that broad asset rallies, even those aided by central banks, cannot go on ad infinitum. Couple this with uncertainty in the economic/geopolitical landscape and plotting the path forward seems to cry out for a more active approach. 20/20 foresight is hard to achieve but worth striving towards in 2020.