As investors turn to hedge funds for portfolio insulation during market turmoil, commodities-focused strategies and event driven managers look to navigate fresh market volatility amid a worsening economic outlook.
As investors turn to hedge funds for portfolio insulation during market turmoil, commodities-focused strategies and event driven managers look to navigate fresh market volatility amid a worsening economic outlook.
The steady rise in oil prices since the end of last year, which has been driven higher by the war in Ukraine, helped strengthen returns among an assortment of hedge fund strategies exposed to commodities for much of the first half of 2022 (see Fig. 4.1). But growing fears of recession have sparked an investor retreat in recent weeks, with the West Texas Intermediate and Brent Crude benchmarks experiencing a price slide throughout June.
Commodities and other raw materials had earlier soared on the back of the ongoing economic thawing post-Covid, with costs further fueled by tightening supply stemming from Russia’s invasion of Ukraine, and constraints on new mining and production activity.
But the renewed volatility in oil and gas markets means hedge fund managers are now urging caution during H2 in light of the June sell-off.
Westbeck Capital Management – whose Westbeck Energy Opportunity Fund trades long and short across the oil sector using futures, options and equities – says the current investment backdrop calls for “a pause on our bullish view and positioning” until conditions are clearer, adding that while the physical energy market remains tight, “summer liquidity is simply dreadful”.
“Increasing recession fears and USD breakout have compounded weaker oil inventory data and led to a very aggressive sell-off across the commodities complex,” Westbeck managers observed in a recent strategy update. “Technically, oil is testing the bottom of the bullish trend we have been in since the lows of the pandemic. A break could send us sharply lower.”
Nick Mazing, director of research, Sentieo, observes how the WTI benchmark and US 10-year treasuries had been moving fairly steadily in line until recently (see Fig. 4.3).
“Is that now over? Some people would argue yes, if we are going into a recession; others would say no, and that there is still plenty more to go in terms of rates and commodities,” Mazing says.
He notes that certain soft commodities are already negative year-to-date, noting that consumer sentiment has worsened and instances of the word “recession” in global corporate conference call transcriptions have ticked upwards in recent months.
“If we are in a recession, then a lot of the momentum shown in oil is going to reverse. The big bull market in commodities might be over, and it is highly likely that 2022 is the near-term peak year for commodities,” Mazing adds.
‘Vibrant’
The reversal is also reflected in the positioning of CTAs, which had earlier made sizable gains from the energy price rally. The trend-following hedge fund sector is said to have flipped to around 10% short in recent weeks, in contrast to the maximum longs of 10% earlier this year.
Recession fears also loomed over the event driven and special situations hedge fund sphere during H1, with managers here ending the first half marginally in the red as the volume of corporate activity tailed off from 2021 (see Fig. 4.2). However, certain specialist funds have captured positive gains in M&A activity, with private capital supporting a number of global ‘mega-deals’ as firms look to insulate their businesses from inflationary pressure.
Maso Capital, a Hong Kong-based merger arbitrage, event driven and convertible arbitrage-focused hedge fund investing across developed markets in the Asia-Pacific region, has generated “differentiated and uncorrelated” returns in what it calls a “vibrant” M&A marketplace.
‘Protected’
“There are large deals and complex cross-border deals with large spreads that we are capturing and those have led to roughly half our returns,” says Maso co-founder and co-CIO Manoj Jain, pointing to a raft of private capital being put to work in restructurings throughout the APAC region.
“Japan is having a top-down, bottom-up paradigm shift in terms of corporate activity that will continue to be the case. In Australia, a wall of private equity money has been raised. You have strategic activity, you have inbound activity, you have outbound activity – there are a number of M&A transactions there.”
Jain notes how there are now higher barriers to entry in event driven and M&A trades as a result of the growing deal complexity and macro concerns. But that has led to less-experienced operators and M&A “tourists” sitting on the sidelines, which in turn means “fewer players, and more opportunities with wider spreads albeit more volatile,” he adds.
“We are able to play across the capital structure, so there are certain scenarios where we can own a convertible bond, rather than the equity, which offers a different up-down profile which we think has been pretty unique. That cross-asset capability has proven very useful in this region.”
“We have been using certain macro tail edges since the summer of last year. We can use derivatives to hedge their overall portfolio – that has helped us whether it’s interest rates, or the NASDAQ, or what’s happening in Ukraine or FX moves.”
Jain continues: “Our strategy is, and continues to be, a well-hedged, event driven portfolio; hedged to the position level with single-name or sector hedges. That approach has protected us as we come through to the event or takeover.”
