The liquidity spectrum: How 2020’s black swans became “the new normal”, confronting hedge fund strategies of all stripes

Black swan

With surges in volatility tipped to become increasingly frequent, so-called “black swan” events are more likely to become part of “the new normal”, speakers at this year’s Hedgeweek LIVE Europe summit heard.

A panel discussion on the relative merits of liquid and illiquid hedge fund strategies – a new addition to the event’s agenda this year – brought together fund managers situated on all points of the liquidity spectrum.

Speakers reflected on how March’s historic coronavirus-driven sell-off impacted their respective strategies, and debated how investors in different asset classes can better manage liquidity exposures as uncertainty continues to loom over markets.

Damien Regnier, portfolio manager, global convertibles at Tyrus Capital, said the March sell-off was the first time the convertible bond market had been tested since the 2008 collapse, adding that liquidity is always the main challenge for this market.

He described his sector as “relatively niche” at about USD600-700 billion in size, but “lively”, sitting at the midpoint between liquid and illiquid.

“Overall, the converts market did very well, which makes it interesting going forward,” he observed, noting how from 2017 to 2019, momentum factors performed solidly, which meant many strategies entered into 2020 “quite loaded” in terms of risk.

“That was not our case,” he continued. “From a macro standpoint, we felt we were late in the cycle so we were already positioning in sectors that were fairly defensive.”

Meanwhile, Mads Ingwar, co-founder and CEO of Kvasir Technologies, believes that “none of us had been able to forecast what happened this year.”

Kvasir Technologies runs a “deeply liquid” fully systematic long/short equity and managed futures strategy, which utilises machine learning across all aspects of the process, including data ingestion, trade signals, portfolio optimisation and assessing liquidity. 

“We trade global equities, we are market neutral and strive to have uncorrelated returns to the overall market,” Ingwar said.  “What our models are able to predict and what they have seen before is how liquidity dries up and how the risk/reward of being invested can change, and how exposures can begin to matter a lot especially as the correlation of everything goes to one.”

The predictive algorithms detected some of the precursors to the downturn in the spring and duly “degrossed” its portfolio, stepping out of certain futures markets to help avoid some of the liquidity shocks.

“Even on our end, the deeply liquid side, you can very quickly have things change,” Ingwar added. “These tail risks you need to manage through correct exposure and having strategies that deal well with varying conditions.”

Albertus Rigter, a partner at Astra Asset Management UK, said his area of focus - structured credit – is on the “least liquid end” of the panel. During March’s sell-off, structured credit “fell much more” than what fundamentals were predicting, as it became very difficult to buy and sell assets.

“Our markets trade through appointment through BWICs, so there is a natural finding between sellers and buyers and those meeting points become more difficult in a crisis,” Rigter explained. “It’s much more risk averse, and it becomes even more risk averse in a negative environment.

“You have to make sure your funds’ liquidity terms are set to the worst environment, not the best environment. Most of our book today we can liquidate in a week or two. But in difficult environment things can change,” Rigter said, adding that quarterly liquidity “is much more prudent” than offering daily liquidity.

“We like to keep cash on the sidelines. It’s not always easy to keep cash because in beta-heavy markets you feel compelled to invest and keep yield in the portfolio.  But we have learned over time that keeping a little bit of opportunistic dry powder really helps you. March was no different.”

The wide-ranging discussion also explored the challenges of being nimble in turbulent markets, investor appetite, return expectations and ultimately how hedge fund allocators can best blend their exposure to liquid and illiquid strategies.

“It’s a basic rule – don’t put all your eggs in one basket,” Regnier stated, adding investors should begin by determining their investment horizon, and from there start diversifying.

“Ten or twenty years ago people were not looking at risk measurement like they do now,” he said. “Now people care about things like VAR, risk managers are part of investment committees - that’s a change in the right direction.”

Rigter meanwhile spoke about the ways in which investors are forced by their mandates to allocate, and stressed the importance of keeping a holistic view of credit markets as an allocator.

“People are looking at markets from a beta perspective too much and on an historic basis a lot of beta markets look extremely attractive,” he said.  “Our strategy is not a straight line. Very often we have flat months, or an up 3 per cent month. What goes up can go down – we can lose money. But investors should have a real fundamental view, not only a quantitative view, especially on the credit markets.”

Rounding off the discussion, Ingwar noted it is a “given” there will be heightened volatility further down the line. As a result, the considerable amount of black swan events in recent times suggests “they are less like black swans and more like the new normal.”

He added: “It’s important that investors take a look at how they are exposed especially in any of the tail risks that are in their portfolios in the period before it becomes relevant, because we will see a lot more tail events going forward.”

If you missed out on attending the HedgeweekLIVE Europe digital summit, which was held on 11&12 November, we recorded the panel discussions and presentations for you to enjoy…

 

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