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Performing under pressure: How hedge funds can weather Q4’s choppy markets

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Hedge funds are well-placed to outperform other assets classes in a potentially choppy market environment during the fourth quarter, with commodities, event driven and certain credit strategies faced with a rich opportunity set and strong upside potential as markets adjust to a post-Covid world.

In its latest ‘Fourth-Quarter Hedge-Fund Strategy Outlook’, K2 Advisors said global equities and bond markets are now locked in a “tug-of-war” between good news and bad news, which is shaping the way investors position their portfolios. 

“Change creates opportunities for those nimble enough to capture the new tailwinds while hedging out the risks associated with a shifting environment,” K2, the hedge fund investing unit of Franklin Templeton, observed.

Specifically, Covid cases are set against tightening central bank policies, stronger employment numbers are balanced against supply chain problems, while solid earnings growth this year face worsening year-over-year comparisons in early 2022.

K2 pinpointed relative value trading opportunities in commodities amid a continued tightened supply and demand environment which has pushed prices up. A range of commodities – crude, natural gas, heating oil and gasoline – have hit multi-year highs recently, and with more economies beginning to reopen, demand for oil and products is set to grow further as work and personal travel increases.

“We look forward to a rich opportunity set, particularly in the energy sector, as volatility and prices increase,” said K2, observing how supply is unlikely to meet demand and noting a “significant lag” between any increase physical production and the result of higher supplies.

“Despite renewed institutional interest, commodity managers have remained disciplined in accepting investments and are managing capacity closely.”

Meanwhile, the adviseFUBDr is also taking a positive stance on event driven hedge fund strategies.

Its outlook is underpinned by a combination of record deal volumes across M&A, leveraged buyouts, buybacks and activist campaigns, as well as attractive spreads, and a “particularly attractive” diversity of outcomes stemming from greater regulatory and geopolitical uncertainty.

Specifically, K2 pointed to greater regulatory involvement in the US and abroad, increased fundamental uncertainties due to changing monetary policies, and more active shareholder and management activism.

“These risks have translated to wider spreads and greater potential upside for managers who can produce alpha through security selection and trading,” they noted.

K2 also favours certain credit-based assets, as well as macro hedge funds. In credit, the prevailing macro picture remains “very supportive”, K2 said, with capital markets offering a solid environment for new issuance since late 2020 and spreads tighter across the board.

“We look forward to higher levels of dispersion among issuers and therefore a better opportunity set for pure credit pickers,” it wrote. “In the meantime, however, managers remain focused on events to generate performance. In high yield, for example, the primary market remains extremely busy.”

For long/short credit strategies, tighter spreads provide better entry points for short positions, the outlook added, while the rebound in structured credit offers dispersion opportunities in commercial mortgage-backed securities (CMBS) and aviation, which depend on the economic reopening.

K2 is also overweight global macro strategies, as managers look to position around the inflationary outlook and its far-reaching impact on monetary and fiscal policy in the US.

As markets are shaped by the policy developments, thematic macro strategies can capitalise on emerging opportunities, K2 said. 

“While shifts in these factors have contributed to volatility and challenged some managers’ positioning in the last quarter, increased clarity on policy paths going forward may support medium or long-term thematic positioning across major markets,” the outlook observed.

“Specialist managers focused on relative value may continue to find opportunities, for example, between commodity exporting and importing countries. The potential for policy certainty to help develop medium- to long-term directional themes and trends may also support systematic macro strategies.”

The forecast comes as new Q3 data published by Preqin this week underlined how hedge funds have continued to insulate investors’ portfolios as market conditions turn.

Hedge funds dipped some 0.27 per cent in the three months between July and September, but still outperformed the S&P 500 PR Index, which was down 0.45 per cent over the same period.

Beyond the headline numbers, several hedge fund strategies remained in the black – macro funds were up 1.83 per cent for Q3, while relative value (0.77 per cent), credit (0.57 per cent), event driven (0.52 per cent), and CTAs (0.77 per cent) were also in positive territory, according to Preqin metrics.

“High levels of volatility and dispersion, and divergence in recovery between countries, have all created attractive opportunities for hedge funds,” said Sam Monfared, associate vice-president, Research Insights at Preqin.

“The upside is still there for hedge funds, and they generally perform well under market pressure. As central banks step away from the markets, volatility will likely increase, and hedge funds will certainly be there to support investors in that environment.”

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