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Market neutral long/short hedge funds’ recent bounce remains vulnerable to factor rotations, says Lyxor

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Market neutral long/short hedge funds have been boosted by the recent bounce in Momentum stocks – but Lyxor Asset Management strategists believe the strategy is vulnerable to sudden factor rotations over the longer-term.

The performance of Momentum stocks has stabilised in recent weeks, following the sharp correction in November, in turn aiding certain hedge fund strategies – such as market neutral long/short – which have a Momentum bias. As Value names have maintained their recovery, and are starting to be shown in the Momentum risk factor, Lyxor said near-term prospects for market neutral long/short hedge funds have “marginally improved”.

“The Momentum bias allows market neutral L/S to capture better economic prospects, now that the correlation with Value is increasing,” senior strategists Jean-Baptiste Berthon and Philippe Ferreira, and hedge fund analyst Bernadette Busquere Arnal, said in the note.

“For investors that are risk constrained, the low volatility features of the strategy coupled with the current cyclical bias are somewhat supportive.”

Market neutral strategies have generated 1.8 per cent year-to-date, according to Lyxor data.

But strategists warned that the strategy remains vulnerable to factor rotations over the longer term, with questions remaining over how long the recent Value trend will last. Additionally, no market directionality will curtail their capacity to capture the economic rebound, with fundamentals back in favour, they added.

Berthon, Ferreira and Arnal believe market neutral long/short funds will likely continue to underperform other hedge fund strategies, adding event driven, CTAs and directional long/short “look more attractive” at this stage of the business cycle.

In particular, directional long/short managers, which outperformed by some 2.5 per cent during the first quarter, have benefitted from the market rebound with an equity market beta of some 44 per cent, according to Lyxor data – “significantly higher” than that of market neutral funds.

“Our stance on the strategy remains overweight to the extent that returns are likely be fuelled by elevated stock dispersion on both sides of the Atlantic and also by their market directionality,” the strategists said of directional hedge funds.

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