The first-half stock market slump caught hedge funds off-guard, but most long/short managers remain confident they can ride out the storm.
The first-half stock market slump caught hedge funds off-guard, but most long/short managers remain confident they can ride out the storm.
As the stock market endured a sustained slide over the first six months of 2022, with the S&P 500 shedding more than 20% (the index’s biggest H1 loss since 1970), long/short equity funds – often considered the cornerstone strategy of the hedge fund industry – fell into negative territory as the slump wreaked havoc on portfolios (see Fig. 2.1).
Despite the negative performance, most long/short equity hedge funds say their first-half returns have either kept in line with, or even exceeded, expectations, according to Hedgeweek research (see Fig. 2.3). That said, more than a quarter (26%) of equity-focused managers believe their H1 showing fell short of their target return, the survey data shows. This reflects the sharp reversal in fortunes experienced by a sizable swathe of long/short managers this year.
Equity hedge fund managers point to a “tremendous amount of money” in the market that has been structurally long in recent years, and designed to participate when assets rise. But this “beta-chasing” approach has not necessarily been proven as skilled in hedging on the downside, particularly after a multi-decade environment of declining interest rates.
“The magnitude of market corrections probably caught a lot of people in the industry off-guard,” says Ben Axler, founder and chief investment officer, Spruce Point Capital Management, of the first-half stock market shocks.
“There are a lot of fund managers that haven’t been through a rate-rising cycle and haven’t really been through a sustained correction, absent the brief market declines during Covid a couple years ago,” Axler observes.
Barry Norris, founder, CEO and CIO, Argonaut Capital, suggests inflation is more structural than either the bond market or the Federal Reserve currently anticipates, which heralds far-reaching consequences across asset classes.
“In the June FOMC the Fed communicated it was willing to kill inflation even if that meant a deep and painful recession; risk assets sold off, whilst treasuries and the US dollar were well bid,” Norris says.
“By the July FOMC, Powell seemed to have already backtracked: he was already worried about the economy, which suggests he is trying to engineer a soft landing, which we think is impossible. He also thought that the ‘neutral rate’ for US rates was just 2.5% which, given CPI is currently 9%, is a conclusion you can only make if you still believe inflation is still largely ‘transitory.”
As a result, Norris – who runs the UK firm’s Argonaut Absolute Return equity long/short hedge fund – believes the Fed has reopened the risk window, meaning that the nominal growth boom is likely to continue.
“This is supportive of nominal assets like commodities but also corporate profits and wages. But for investors – whose returns are being eroded by inflation – it is mainly negative, and should result in a continued contraction of valuations of all financial assets.”
‘Value’
Looking ahead, long/short equity hedge funds remain confident in their ability to weather continued stock market turmoil. More than 40% of equity-focused fund managers surveyed by Hedgeweek say they are “somewhat positive” about their performance prospects for the remainder of 2022, with a further 16% taking a “very positive” stance on their H2 outlook (see Fig. 2.4). Nevertheless, more than one in every four managers running equity-focused hedge funds have a “negative” outlook on the rest of the year.
“Long/short equity has been challenged, but this is the strategy that was the best performing strategy from 2017 through to and including 2020,” says Dave McMillan, CIO, hedge funds at Mercer. “So we still believe a diversified approach, a mix of managers and a mix of strategies, is the best way. I do believe there’s some embedded value in long/short equity portfolios and I’d like to think maybe the worst is behind them, but that remains to be to be seen.”
So, in light of long/short managers’ continued upbeat stance, where can strategies hope to generate returns during the second half of this year?
Industry participants note how the environment for equities will potentially remain challenging, with possible difficulties in finding reliable longs coupled with increased volatility in crowded shorts.
“In periods like this, investors become more discerning on what they own and some of the weaker companies tend to get punished a little bit more in a bear market, whereas in a bull market, some investors might give these types of companies a pass and overlook certain things,” says Axler. “We look for promotional companies and companies with high aspirational goals, and so when the business environment gets weaker, those goals tend to be missed and when corporates miss goals, investors tend to punish them by selling their stocks.”
Building on this point, Axler says: “We’re more than just directional short sellers – we look for companies that we think have problems in their business, or are using aggressive business practices, or have problematic accounting, or bad financial statements.
“That’s why we think the background is more conducive for us because investors are paying more attention to what they own in their portfolio as we’re on the precipice of a recession, and generally companies missing their targets and missing their goals.”
‘Hedging’
Further afield, David Amaryan, founder of Balchug Capital, which trades long/short equities and fixed income on an event driven basis with a geographic focus on Russia and the former Soviet Union, has tapped into range of value opportunities that emerged from the forced selling of equities at the onset of the Ukrainian war.
“This market has been at a very steep discount, but right now if you are willing and able, and you have the knowledge and experience to be here, I don’t see anywhere in the world where you can get the kind of upsides you can get within a year that you can get in Russia, if you know what you are doing,” says Amaryan, explaining how his strategy has taken positions in both OTC stocks and fixed income assets in Russia and the former CIS territories.
“In the beginning of the year, we were light on Russia – we were expecting some sanctions and some turbulence, but to be honest none of us expected any kind of escalation of this type. This is our market, our home turf, we know it very well.
“It’s not just us; there are other investors like us – smaller western hedge funds and US family offices who are not bound by various regulatory and social pressures who are out there looking for these assets and buying them. There’s a market already – people who have to sell, even if they don’t want to, and people who want to buy,” adds Amarayan. “We are an event driven fund, so when events of this magnitude are happening in one of the main markets we focus on there is no way we can sit on the sidelines.”
Axler says: “The operative theme centres around who was hedging and who wasn’t hedging. We will probably see what separates the winners from losers, or specifically the ones that have been able to either mitigate, or take advantage of, the declining asset prices, and opportunistically take advantage, or hedge, that downside risk.
“We are in the hedge fund industry, and hedge funds were borne out of the idea that investors could play both sides of the market, both long and short.”
