Investors are slashing their exposure to hedge fund products at the “worst possible time”, says Man Group’s Pierre-Henri Flamand, amid signs that the long bull market run is starting to run out of steam – throwing up new opportunities for actively-managed strategies.
In spite of a strong year for hedge funds in 2019 – up more than 10 per cent for the year, their best performance in a decade – they were still comfortably outflanked by equity benchmarks, with the S&P 500 climbing more than 31 per cent as the stock market sustained its strong momentum.
Now, though, Flamand – Man GLG’s CIO emeritus and senior investment adviser – believes there are “increasing signs” of a new, less benign phase of the market cycle looming. This evolving new backdrop is characterised by a pick-up in volatility and increasing dispersion between stocks that justify their valuations, and those whose prices have been swelled by hitherto benign environment.
Dispersion is likely to increase with the turning of the cycle, meaning that firms that offer in-depth fundamental analysis have the potential to outperform, he said.
“When markets turn, active management underpinned by deep fundamental analysis and robust trading systems is critical,” he observed in a research note this week. “At these points, the nimbleness, perspective and focus on alpha-generation that are the basis of superior hedge fund performance come into their own.”
Middling performance, coupled with grumbles over fees and the comparative outperformance of the equity market, have seen investors eschew actively-managed strategies – such as hedge funds – in favour of passive tracker products.
Collectively, allocators yanked some USD43 billion out of actively-managed strategies last year – following some USD38 billion in outflows in 2018 – while at the same time pouring some USD571 billion into ETFs.
But, looking ahead, Flamand suggested this secular shift to low-cost ETFs has led to crowding in this area, which may offer future arbitrage opportunities for hedge funds to exploit.
Hedge funds’ historically uncorrelated return profiles have been “largely overlooked” as investors have benefited from the correlation of traditionally uncorrelated products – such as stocks and bonds – during the latest bull run, which has been underpinned by calm economic conditions, supportive monetary policy, technological innovation and low inflation.
That has prompted a “degree of soul-searching” among hedge funds managers, according to Flamand.
“Hedge funds tend to underperform stocks in periods of extremely low volatility, and in a world where shares only travel benignly in one direction, managers will rarely justify the fees they charge.
“If you believe that this situation will persist ad infinitum, then you should not be concerned by correlation; however, if you think that markets will eventually correct, and exposure to market risk should be managed, then you may want to consider keeping alternatives a key element of your portfolio,” he added.