Tide may be turning for market neutral hedge funds

Turning tide

Equity market neutral hedge fund strategies could be set for a reversal of fortunes, as trading conditions normalise towards 2020’s midway point. 

New research by Lyxor Asset Management indicates market neutral managers suffered “underwhelming” returns earlier in the year following rapid stock correlation and sizeable rotations across factors and sectors, with short trades failing to deliver.

Now, though, normalising trading conditions could prove more supportive for market neutral funds, as recent bets on smaller cap names and growth factors boost alpha, strategists said this week.

“The environment is improving for long/short neutral strategies, but the fast-changing trading conditions keep us in wait-and-see mode for now,” senior strategists Jean-Baptiste Berthon and Philippe Ferreira, and hedge fund analyst Bernadette Busquere Arnal, noted in a market commentary.

In line with most other hedge fund strategies, market neutral funds saw performance struck down amid the sustained turmoil that underpinned markets during the initial spread of the coronavirus earlier in the year.

But while other equity-focused strategies soared during the subsequent stock market rebound, market neutral funds’ gains were comparatively modest. Market neutral managers rose 1.09 per cent in April and 0.31 per cent in May, according to Hedge Fund Research data, while the HFRI Equity Hedge (Total) Index benchmark was up almost 7 per cent in April and 4 per cent in May.

Extreme volatility, along with the dominance of speculative drivers – such as the Covid-19 crisis, multiple stimulus and the oil price war – and heavy systematic trading ultimately combined to squeeze fundamental stock-picking approaches, Lyxor said this week.

They were also pummeled by a series of factor rotations – with momentum initially taking hold during March’s crash, followed by a surge in value versus growth stocks during the rally, which later reversed.

However, market conditions may now be starting to improve, which could boost neutral strategies’ fortunes.

Another major value versus growth catch-up – which could hurt market neutral hedge funds – seems “unlikely” at this stage, while dispersion across managers’ returns is also “a good sign”, and consistent with the ongoing normalisation of stock correlation and dispersion.

“Long/short equity neutral strategies have deeply reshuffled their allocations away from value, quality, and defensive stocks. They have gone into smaller caps and growth factors,” they observed in a note this week.

“These changes, along with a broadening sector leadership, a deeper focus on stock fundamentals - especially in the small- and mid-cap segments – and improving shorting conditions, all helped generate positive alpha.”