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Chapter Five: Allocator Sentiment

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Tilo Wendorff, Managing Director and Head of Absolute Return, Prime Capital AG

After two volatile but prosperous years for the hedge fund industry, managers and investors alike are faced with a multitude of near-term uncertainties. To name just a few crucial ones, there are uncertainties around the ongoing evolution and impact of Covid-19, and around central bank policies with respect to possible rate hikes, as well as their stance towards inflation and whether it is transitory.

Furthermore, there are geographical tensions, like the ones over in Taiwan or in the Ukraine, and we have ongoing supply chain disruptions, which we can see and feel in our everyday lives. While uncertainty and volatility can be rather unpleasant for classical buy- and-hold investors in the traditional asset classes, this environment is very favourable for equity market neutral, relative value and trading- oriented strategies – all of which we believe should be core to a well- balanced hedge fund portfolio.

In 2020 and 2021, alpha- as well as beta-driven hedge funds alike were able to perform at their best, but this will be put to the test once more in 2022. With a potential regime shift on the horizon, it is wise to err on the side of caution. With this in mind, we think a low exposure to all market-dependent hedge fund strategies is prudent, and we emphasise a focus on alpha-rich strategies or niches that are independent of broader markets.

Next to the traditional hedge fund strategies, we see a lot of interesting investment opportunities arising from the realm that resides between the world of hedge funds and private debt investments. We see various interesting alternative credit strategies, with hedge fund-like liquidity, but short-term private debt return profiles. These strategies exhibit a reliable and rich return potential, have little market
dependencies, and a strong security package.

Finally, though importantly, ESG is slowly but steadily making its way further into the hedge fund space. While there are currently no unified investing or reporting standards available, which leaves many open questions (is shorting CO2 emissions heavy stocks positive, for instance?), we are certain that those roadblocks will be overcome sooner or later. Therefore, we have started to survey hedge fund managers regarding their stance on ESG matters and, while the vast majority are still in their infancy, nearly all have started to take this topic seriously. We have been positively surprised by the current state of the industry and we are looking forward to launching more initiatives, especially around improving the environment and our society as a whole.

Marc Syz, Co-Founder, Syz Capital

At Syz Group, we see value in alternative UCITS funds. The lower expected returns, mainly due to less leverage and concentration than classic hedge funds, are compensated for by better liquidity. This flexibility allows us to be more trading-oriented when managing an alternative UCITS fund portfolio. We also remain convinced of the value of convertible arbitrage and merger arbitrage strategies that can provide diversification, thanks to their lack of correlation with the wider market.

China’s increasing healthcare needs and medical innovations, driven by rising wealth and an ageing population, are generating new opportunities. China’s population is currently spending a fraction of what developed countries are allocating to healthcare. As Chinese firms roll out broader access to health services, finance biotechnology and medicine to meet demand, we believe this will provide sound entry
points for investors. Recent months have underlined the need to invest in the most robust sectors of China’s economic evolution.

Regulation and rapid growth have made this challenging, but we believe that the healthcare theme will generate returns. We are working with specialist managers in Hong Kong, mainland China, and the US to follow developments and evaluate the potential of each innovation. While China’s medical innovations still lag the progress of European and US developers, the resources devoted to improving healthcare mean that the sector looks poised to experience a wave of progress.

More widely, equity markets are reacting to normalising monetary policy. Central banks’ emergency asset purchases lifted markets through the pandemic and undermined the incentive for investors to examine stocks’ fundamentals. This year, we saw an extremely difficult environment on the short side due to the Reddit ‘short squeeze’ and a lack of dispersion between long and short positions. Large movements at the level of industry sectors followed macro themes. This made it the worst environment for generating alpha in more than a decade for equity managers. All that has now changed, as developed economies’ central banks discuss raising interest rates and tapering their asset purchases.

In the meantime, many investors were reminded of the resilience that hedge funds can offer. As a result, markets are paying more attention to earnings and company outlooks. Over the short term, we therefore expect earnings surprises to translate into increased volatility, as investors begin to differentiate within sectors again. This is very positive for our stock pickers looking for alpha generation.

Yehuda Spindler, Chief Investment Officer, Optima Asset Management

While Optima’s focus is often mandate specific, in general, the expectation for our lower volatility offerings is a continued focus on absolute return and uncorrelated strategies across the CTA, Global Macro, and multi-strategy landscape; for our more directional strategies, a continued emphasis on equity specialists remains in place.

Given our expectations for more pronounced monetary policy tightening, credit remains an underweight exposure. The increased volatility we observe around the globe, along with record low interest rates and exceedingly high equity valuations, led us to prioritise managers who have the ability to protect on the downside, while affording reasonable upside during bull market runs. We remain committed to creating innovative strategies that are both compelling and differentiated in the hedge fund space.

A number of new trends and developments are taking hold within the hedge fund space. Several high-profile firms have been launching longer lock-up share classes, particularly within multi-strategy funds, to more effectively compete in terms of attracting talent, while mitigating business risk. On the product side, more hedge fund managers have been launching long-only vehicles in addition to hybrid funds designed to invest across both public and private opportunities. The ability to leverage research within a more flexible investment mandate has been a key driver behind this innovation. Overall, Optima believes these trends will continue to accelerate, as hedge funds expand their scope and research capabilities.

Over our more than 30-year history, we have allocated to both generalists and sector specialists, given our belief that both types of managers have merit in a multi-manager line-up. In recent years, our sector specialist exposure has been expanding as we prioritise managers with sustainable competitive advantages in their respective areas.

From a thematic standpoint, we remain particularly constructive on the technology, consumer and healthcare sectors, given the strong secular tailwinds. However, we expect to be active in more cyclical parts of the market if we identify compelling stewards of capital.

Emerging managers have and will continue to be an important component of our hedge fund universe. However, manager quality, experience and expertise are of utmost importance and, as a result, we have a very high due diligence threshold across all investment candidates.

As ESG has become a more critical factor for investors around the globe, Optima’s focus on incorporating ESG considerations into the portfolio process has also risen. We are continuously trying to improve the impact of ESG criteria in our manager selection process. As a result, we are refining certain procedures to attempt to ensure that ESG priorities are a primary component of our due diligence process.

Donald Pepper, Co-CEO, Trium Capital LLP

Trium is backed by a family office that takes a traditional approach to alternative investing. Namely, the goal is to stay rich and get richer slowly. This guides us to seek portfolio managers whom we expect to be able to compound steadily, with a strong focus on avoiding or dampening down drawdowns. We will not be chasing equities at current valuation levels, nor will we be making any allocation to long-only bonds and credit. Rather, we are seeking fixed income replacement strategies to back with our own capital.

These strategies include, firstly, Global Convertible Arbitrage. The strategy has demonstrated excellent downside protection, while generating strong positive returns. The universe of convertible bonds has grown hugely in the past 18 months, creating a substantial opportunity set to generate alpha while hedging equity beta, credit and interest rate risk.

A second of our strategies, Global Discretionary Macro, favours a truly global approach, i.e. including emerging markets (with a focus on Latin America and Eastern Europe) to complement the more-travelled G7 markets. This has led the strategy to have strong returns with a negative correlation to equities over its 10+ year history. We expect 2022 to provide excellent opportunities for the strategy.

We have backed a European-focused discretionary equity market neutral strategy driven by an ESG approach that seeks both to engage constructively with companies to reduce emissions, as well as achieve uncorrelated returns. We provided seed capital for this strategy almost three years ago and it now has over 30 additional investors.

Returns last year were boosted by the allocation to our quantitative (low net) dynamic equity strategy. This strategy has a 19-year heritage, and we see continued opportunity for that strategy in the years ahead. In addition, we are incubating a very interesting global equity capital markets arbitrage strategy to take advantage of the huge activity and planned activity in ECM and other arbitrage opportunities over the coming years.

Each of these meets the principle of expecting to deliver positive returns over a rolling three-year period, with low correlation to what we expect to be potentially quite volatile markets in 2022.

Trium has pioneered a hedge fund strategy that has utilised ESG as a means to generate expected alpha. Back in late 2018, while Joe Mares (ex-GLG and Moore Capital) developed the strategy, there were a lot of naysayers who stated they believed that incorporating ESG criteria, would reduce returns. I am glad to say that conversation has well and truly moved on. Investors understand that ignoring ESG criteria is not consistent with trustees fulfilling their fiduciary responsibility.

We expect more hedge funds to genuinely embrace ESG principles and use these to drive return generation. This will satisfy the growing demand we are seeing from investors for such strategies.

Our ESG emissions impact strategy is a multi-sector fund that focuses on companies in the sectors accounting for approximately 30 per cent of market capital yet causing approximately 90 per cent of global emissions. The industry and specific expertise of the portfolio manager and his three analysts in these defined sectors allows them to identify companies that are embracing ESG, and who they see as outperformers (in the long book) vs ESG laggards (shorts) we expect to underperform in the cross-section of these sectors. As such, we can establish well-hedged long/short trades where returns are driven by idiosyncratic stock vs stock alpha, rather than being whipsawed by factors (eg growth vs value) as some broader generalist hedge funds have been.

We, and the family office backing Trium, are big believers that there is incremental alpha to be harvested by investors willing to back emerging managers. It is important not to confuse “emerging” with “novice”. The typical emerging manager we back has well over a decade of hedge fund portfolio management experience. As they embark on launching their own fund, with their own capital at risk alongside ours, we see extreme levels of focus that, along with more reasonable fees (it is a zero-sum game – lower fees mean higher returns to investors) and lower AUM, we believe will deliver an emerging manager premium.

Suzanne Dugan, Investment Specialist and Matt Hoehn, Co-Head of Customised Asset Allocation, TIFF Investment Management

While the hedge fund industry not strong returns in the decade after the financial crisis, and had fallen out of favour for some time, it performed quite well over the course of 2020 and 2021. This improved performance, combined with the recognition that the state of the economy and markets may be conducive to active management, has increased flows into hedge funds.

Due to the reasons above, we have seen priorities shift with regards to hedge funds. We have seen a similar dynamic at the industry level.

TIFF focuses on managers who invest in niche and inefficiently priced sectors, geographies and/or asset classes. The managers are often narrow in scope with deep expertise in their investment vertical and have a sustainable competitive advantage – many are capacity constrained. Lastly, we look for managers who have demonstrated their ability to preserve capital in market drawdowns and have shown asymmetric returns. We will continue to focus on niche managers in 2022, in areas such as small and mid-cap energy transition, fintech specialists, Chinese healthcare, equity long/short, and Japanese small/mid-cap equity long/short investments.

Our most recent hedge fund investments have been with managers focusing on the global carbon markets and, in particular, managers with exposure to mandatory physical California Credit Allowances.

Our hedge fund programme emphasises strategies that are narrow in scope and deep in expertise, which leads us to invest in specialist managers over generalists.

The majority of our new investments are emerging managers. Some of our longer-term partnerships begin as emerging managers, but transition to being more established.

We continue to believe that US hedge funds who are lagging long- only managers and European hedge funds in ESG, will attempt to include ESG into their investment processes. TIFF conducts an annual DEI/ESG survey with its hedge fund managers. We launched the TIFF Sustainable Fund in June 2020, which is a comprehensive strategy, including 65 per cent equity long only managers, 20 per cent hedge fund managers, and 15 per cent fixed income. Managers selected for this strategy have either a thematic focus or have already implicitly or explicitly incorporated ESG into the investment process.

According to Chris Matteini, Head of Investment Research, Sustainability and Equity-orientated assets, it is TIFF’s belief that US hedge funds are slowly catching up to European hedge funds and the global long-only community when it comes to incorporating ESG into their investment process. TIFF’s recent research on the global carbon markets is one example of US hedge fund managers investing in a carbon-reducing asset class.

Sloan Smith, Principal and Director, Innovest Portfolio Solutions

We will continue to focus on the multi-strategy space in 2022, as the risk/ return profile for these strategies still looks attractive. In 2020 and 2021, we continued building a core position in hedge funds. We’ve built a core allocation, which is more of a multi-strategy allocation, to solve the issues we’ve experienced with regards to fixed income. These have more bond-like characteristics, but with only slightly higher volatility. Obviously fixed income is very liquid, where hedge funds are not, but these investments were great at keeping risk low, and worked well to minimise drawdowns. Markets have experienced several periods of volatility over the past two years, but we didn’t experience any heavy drawdowns in our hedge fund allocations, which was tremendous.

We prefer generalists over sector specialists. We’re looking for robust diversification in our hedge fund portfolios. While we do allocate to equity long/short and to some credit strategies, we like to focus on multi-strategy businesses with good teams, such as the Elliott Managements, the Millennium Managements, the Citadels, who are able to capitalise on areas of a strategy where there’s some opportunity, depending on the markets. In 2021, we saw our multi-strategy firms allocate capital very seamlessly to credit. Our multi-manager platforms were great at mitigating drawdowns and allocating to areas of the market, such as energy and financials.

In terms of new and developing trends, we expect that we might see some more spin-offs from larger hedge funds, especially among star portfolio managers.

In 2022, we will almost certainly spend most of our time on established names. We conduct annual reviews, and last year we found that managers performed well. We saw a very small percentage of managers getting caught up in areas such as the options market, where they weren’t underwriting the lack of liquidity and blow-up risk but, on the whole, it was very few. In 2022, we’re looking to work with hedge fund managers who are passionate and who are constantly looking ahead in terms of their business philosophy and growth. We ask each manager whether ESG is part of their investment philosophy, and we want to see strategies consider this item in their process over the coming year.

Patrick Ghali, Managing Partner and Co-Founder, Sussex Partners

Demand for hedge funds in 2022 should remain robust. This demand is driven by the fact that markets appear to be quite toppy on several metrics and, hence, investors are continuing to look for better risk-adjusted alternatives, portfolio diversification and sources of independent alpha.

Additionally, demand for fixed income alternatives should be significant given that the low yield conundrum isn’t likely to be resolved anytime soon, even if rates may increase this year, which of course may also lead to losses on existing traditional fixed income allocations.

ESG-related strategies are also expected to continue strong demand, both due to regulatory changes, and an ongoing trend towards inclusion of ESG considerations in portfolios. This can be seen across our portfolio of clients, though certainly more strongly for European clients. China and Japan will also continue to be geographies of interest, not just on a valuation basis, but specifically because Japan should continue to stimulate its economy significantly without having to worry as much about the risk of runaway inflation, this should create interesting opportunities.

With the ongoing uncertainty around Covid-19, divergent interest rate regimes, and late cycle volatility, hedge funds should provide investors with independent sources of returns and protection in case of a correction. Having an element of non-correlation/protection also allows investors to take risks in other parts of their portfolios. The biggest risk for hedge funds in 2022 will be an environment of rapid reversals and frequent regime changes, which can lead to managers getting axed.

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