“Substantial” market rotation will offer fresh alpha opportunities in second quarter, says K2 Advisors

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Merry go round

Hedge funds can capitalise on a “substantial” sector and asset class rotation during the second quarter, as an uneven economic recovery, bumpy vaccine rollouts and an inflationary environment drive dispersion across industries, K2 Advisors said this week.

As global economies begin to unlock, stock-picking hedge funds can look to generate alpha across different countries and sectors as uneven vaccine roll-outs and possible third Covid waves - and subsequent lockdowns - drive dispersion across markets.

At the same time, an inflationary environment may herald a sector and asset class rotation by investors, according to K2 Advisors, the hedge fund investing unit of Franklin Templeton.

Brooks Ritchey and Robert Christian, co-heads of investment research and management at K2, said certain sectors in the equity and investment-grade debt markets are priced for a strong recovery, while other sectors offer better “forward-looking value” opportunities, having not participated in the recent rally. Similarly, a potential inflationary environment will impact different sectors in different ways, they added – a scenario which typically leads to “substantial sector and asset class rotations” among investors.

“Active managers nimble enough to adapt to this new regime should be able to generate responsible returns,” they wrote in K2’s ‘Second-Quarter Hedge-Fund Strategy Outlook’ this week.

“Hedge fund managers able to shift to the cheaper, cyclically focused, inflation-friendly companies while hedging out market risks using short positions in over-owned and overvalued securities should benefit, in our view.”

Specifically, a rotation cycle would tend to favour long bets on stocks and bonds in materials, industrials, financials and energy amid the burgeoning economic recovery, while certain equity and debt positions in tech, healthcare and consumer staples could be seen to be fairly valued during the prevailing work-from-home environment, they added.

“Hedge fund managers able to go long and short equities or corporate debt feel the gap in sector relative values has begun to close,” Ritchey and Christian said.

“Being long the securities that have lagged broader markets over the past few years while hedging out market risks using securities that are relatively overvalued should be a source of low-volatility returns.

Looking ahead, K2 – which provides a range of hedge fund and alternative investment products including single investor custom-tailored investment programmes, commingled funds of hedge funds, and strategic advisory structures across multiple strategies – predicted international equity markets would outflank US stocks in the coming weeks.

Specifically, international cyclical equities will be boosted by a combination of secular trends, rising US interest rates – which have squeezed tech and certain other outperforming high-growth sectors lately – and the looming possibility of US corporate tax hikes.

“Even a potential third-wave lockdown and bumpy vaccine rollouts, as demonstrated by various countries’ responses to AstraZeneca’s vaccine, can lead to asymmetric responses to the reopening trade, enabling dispersion and alpha generation across the different geographies and sectors,” Ritchey and Christian noted.

Elsewhere, K2’s Q2 outlook also flagged up the burgeoning opportunities that are emerging from macro trends.  Against a backdrop of gradual economic recovery, Ritchey and Christen pointed to Citigroup’s Economic Surprise Index which recently highlighted strong macro outperformance compared to the expectations of many economists.

“An environment in which such trends persist may support managers and strategies that are principally focused on such factors,” they wrote.

They added: “From our vantage point, we sense the equity, bond, currency, and commodity markets began a regime shift during the fourth quarter of 2020. Many of the geographical, asset class, and sector rotations associated with this regime shift can be beneficial to actively managed portfolios.”