The market correction that ripped through Q4 2018 was perhaps a pre-cursor for increased volatility this year, and if that is the case, active fund managers – especially specialist sector-focused stock pickers and short specialists – could make substantial gains for their investors.
The volatility index (VIX), which some like to call the ‘fear and greed’ index, spiked above 36 on Christmas Eve while the Dow Jones crashed below 23,000 on 20th December: a 4,000 point decline from its October peak.
This shake-up was largely driven by macro factors and was, in many respects, a necessary event to release valuation pressure that has been building in US equity markets in one of the longest bull market rallies since the Second World War.
The question for investors in 2019 is whether hedge funds can step up and deliver sustained alpha in a higher volatility environment.
Some of the most famous managers continued to shine such as Ray Dalio’s Bridgewater, whose flagship Pure Alpha strategy generated 14.6 per cent net of fees, as reported by CNBC. D.E. Shaw produced similar returns for its Composite Fund, returning 11.2 per cent in the year, while another titan of the industry, Renaissance Technologies, saw its RIDGE Fund generate returns north of 10 per cent.
These managers are the apex predators, accessible to only the largest institutional investors and as such represent a tiny percentage of the overall industry.
Not that they all did well. Some funds, such as Dan Loeb’s activist-focused Third Point had a challenging year, reportedly down 6 per cent in December alone, according to CNBC.
The influence of passive investments, whose popularity has skyrocketed since the Global Financial Crisis, has created real problems for hedge funds. Those who trade the markets based on deep fundamental research were swept into the vortex in Q4 as ETFs and other passive products recorded losses. Hedge funds who operate perfectly sound trading strategies designed to generate uncorrelated returns could not help but be buffeted by index moves.
As CNN reported, the S&P 500 was up or down more than 1 per cent nine times in December and 64 times for the calendar year. “In all of 2017, that happened only eight times,” it reported.
Hopefully, what this shake-up will do is bring markets back to earth and operate on fundamental principles, rather than be artificially inflated by years of central bank intervention.
If it does, this could augur well for specialist hedge funds who operate in the middle-markets, away from the titans referred to above, and allow them to demonstrate why, in more challenging markets – rather than a one-stop bull market rally – hedge funds can deliver good risk-adjusted returns, that passive investments simply cannot.
“Some of the new managers we were working with in Q4 have now either launched or are preparing to launch,” comments Jack Seibald, Global Co-Head of Cowen Prime Brokerage and Outsourced Trading. “I think we will see more funds close this year that have long outlasted the patience of their investors. The downdraft didn’t happen until deep into the fourth quarter. Many funds have 90-day redemption periods so even if redemption notices were filed at year-end it could be another couple of months before we see those redemptions being met.”
Kieran Cavanna is the co-founder of Old Farm Partners, a New York-based FoHF manager that focuses specifically on small and mid-sized managers. Cavanna previously managed the hedge fund selection team at Soros Fund Management.
He says that while no one can ever know how the markets will perform, “I do think it’s a good time for hedge funds. The small and mid-sized space looks really attractive. We are allocating to a number of strategies including equity long/short, event-driven and global macro and I’m positive on 2019.
“You saw big dislocations in Q4 but risk assets have ripped back up in the last few weeks; biotech as a sector is up 11 or 12 per cent alone. Things are more volatile, it could go either way, but I think a lot of managers who are geared towards volatility and thrive, come what may, could do very well this year,” says Cavanna.
In his view, the markets have gotten distorted because of the market cap-weighting of all the money that has gone in to passive funds and index products.
“I can’t say whether that will persist or end but I do think the flood of passive money has slowed and many distortions that have been built up could unwind to some degree… I’m not hearing the whole ‘Well, I can just buy the S&P 500 for 5 basis points’ argument from investors at all any more. Nobody knows whether we will enter a recession in 2019, how much further bond yields might tighten. I do think selective allocations to specialist active stock pickers could be on investors’ minds this year,” he says.
Seibald notes that the drops in market values in December were both “precipitous and sustained”. “Yet in the first four or five trading days of January, some of our managers were up substantially: a few as much as 20 per cent. The selling pressure abated and stocks found their footing again,” says Seibald.
“The question is, do investors judge hedge fund managers on interim results or the realised value of the investments they’ve made? It’s the USD64,000 question. How patient is the hedge fund allocator community going to be? I saw funds down 10, 15 per cent in December alone and they’ve nearly recovered those losses in January. They haven’t reached their high watermarks of three months ago, but they’ve certainly regained a good percentage of the drawdowns we saw in December.”
Much of the volatility in Q4 was macro-driven and linked primarily to fears of what the US Federal Reserve would do regarding interest rates and the impact that Chinese tariffs could have on the US market.
“When you have a correction that aggressive, in terms of the speed and magnitude of volatility, correlations go up,” says John Rende, founder and portfolio manager of Copernicus Capital Management, a specialist equity long/short healthcare fund based in San Francisco.
“I was quite concerned about the impact that these macro events would have with regards to the correlation effect. I brought my gross and net exposure quite far down and basically had a flat fourth quarter; ending the year overall with double-digit returns.”
Rende has been running healthcare portfolios for more than 18 years. He has lived through two severe bear markets, yet still managed to generate positive returns in both: from 2001 to 2002, and 2008 to 2009. His historical strategy has been to manage gross and net exposures around just the kind of volatility events seen in Q4 2018.
He says the market backdrop has become more unpredictable and risky “so staying defensive is warranted”.
“I’ve told my investors that there are markets to invest in, and markets to be more nimble in; and I believe we are in the latter,” explains Rende. “A good 80 to 90 per cent of hedge fund managers today probably haven’t seen a bear market. We’ve been in a bull market for the past eight years or more. It is a time to be more nimble and thoughtful around trading than it is to be a steadfast investor.”
This nimbleness and dexterity could benefit smaller hedge funds more than their larger, billion dollar peers who do not have the capacity to trade opportunistically as doing so would be too big a signal to others, causing the markets to move against them.
As such, if there is a return to volatility and more fundamental trading activities, US mid-sized managers could be well positioned to capitalise.
Ben Axler is the founder and CIO of New York-based Spruce Point Capital Management, LLC; a specialist short-focused hedge fund. “Uncertainty and volatility go hand in hand,” Axler tells Hedgeweek. “The main drivers of that uncertainty remain in play. In our view, one of the causes of that volatility has been a miscommunication or misunderstanding regarding the path of interest rates here in the US and what the Fed plans to do. And secondly, the continuing trade war and the inability to resolve the dispute between the US and China.
“Our strategy is predicated on doing in-depth research on companies and reasons why we think investors should sell or underweight their shares. We find investors are increasingly interested in hearing about the risks of investing in a company during periods of higher volatility. To some degree we see 2019 as a continuation of last year.”
Despite the Fed’s willingness to raise interest rates, on an absolute basis they are still quite low. If the Fed is committed to raising rates in 2019, however, Axler thinks this will lead to valuation compression. Last Nov/Dec was a wake-up call that investor complacency was finally put on notice.
“The easy money people have made over the last number of years is going to be harder to replicate and investors are going to need to be more discerning and careful with where they place their bets,” suggests Axler.
Asked if it has become harder to trade with a short bias in a market that has been dominated by passive investments, Axler considers for a moment, before responding:
“It’s a fair question and something we think about at Spruce Point. There has been a clear move towards passive investing and on the margin that hurts hedge funds that do fundamental analysis. Some of the companies we’ve written about are index owned, and they don’t seem to care whether or not management teams are behaving poorly. All the index cares about is maintaining an appropriate weighting of that stock.
“We’ve had to therefore refine our investment strategy. We’re looking for companies that have a more engaged shareholder base and are willing to listen. That is more powerful to us than attempting to engage with an unengaged shareholder base…large asset managers or ETF sponsors who might own 20 per cent of a multi-billion dollar company who we know aren’t going to read our research.”
Alignment of interests
2018 saw a couple of significant US hedge fund launches led by D1 Capital and ExodusPoint Capital, both of which raised several billion dollars.
In Cavanna’s view, these launches are somewhat anomalous, coming at a time when other larger hedge funds are closing.
“In general, I’m not seeing a lot of hedge fund start-ups other than the mega start-ups, which is really interesting,” says Cavanna. “I think you’ll see a number of large hedge funds going out of business this year because performance hasn’t been good enough for some time. I’m not seeing the next big wave of talent yet there are still lots of hidden gems out there if you look hard enough – I think huge start-ups signify to me that there is simply a lot of money trying to find a home and when you don’t have a track record but you have an amazing pedigree, it helps to entice investors.
“At Old Farm Partners, we look for proven managers running USD100 million to USD1.5 billion. There is a huge opportunity for managers in that AUM range. They can react and move to the market. If you’re a lot bigger than this range – running several billion dollars – that’s not possible, especially on the short side. They just can’t change course quickly enough, the way smaller managers can. The smaller managers can really move with the opportunity set faster, and in a world where everything is moving a lot faster this is critical to good risk-adjusted performance.”
Management fees drive behaviour
For Cavanna, it is as simple as getting the right alignment of interests. A hedge fund with USD5 billion in AUM that charges 2/20 earns USD100 million a year in management fees… that’s not what Old Farm Partners is looking for.
“My best fund is USD280 million, the manager charges 1/20, meaning he earns USD2.8 million a year to run the business and employ a team of four people. But if he has a good year of performance, he benefits from the upside. The incentives for a much larger hedge fund running say USD5 billion is clear to me; it is the management fee that drives their behaviour.”
He says that the portfolio, which consists of 17 hedge funds, currently holds three specialist healthcare funds and two technology-focused funds, all five of which made positive gains last year.
“I think healthcare is by far the best sector for equity long/short strategies – there is such a wide range of things going on in that sector from technology disruption to scientific advances, as well as great short opportunities coming from drugs that lack strong commercial potential. Technology has similar dynamics. Those two sectors are our biggest allocations and will continue to be,” asserts Cavanna.
Whereas the HFRI Fund Weighted Composite Index ended 2018 down -4.49 per cent, the HFRI Sector – Healthcare Index was up 2.62 per cent.
Specialist hedge funds like Copernicus benefit from exploiting opportunities in the broad array of stocks within US healthcare and biotech, limiting the impact of global macro headwinds that might otherwise affect generalist equity long/short funds.
As Rende articulates, “as a sector specialist, it provides a lot of variety in where to invest and trade”.
He says that while there are a lot of high risk, high beta biotech stocks, there are equally plenty of trading opportunities in lower risk, lower beta healthcare services, and to a lesser degree medical devices.
“What I’ve done with my portfolio is emphasise higher quality stocks in companies with less of a macro exposure in sub-sectors such as the tools and instruments space – companies such as Illumina, (ILMN), Thermo Fissure Scientific (TMO), even Intuitive Surgical (ISRG) that have little macro risk and are not correlated to overall economic concerns. I don’t want to take binary high beta risk. I’d rather invest in businesses that are well diversified, generating cash and have little or no correlation to the overall macro risks that exist in the wider marketplace,” explains Rende.
At Spruce Point, Axler believes that the US technology sector is “fertile ground” to seek out certain technology companies that have received high valuations yet don’t make money.
“One of our successful shorts last year was 2U (TWOU),” says Axler. “Seemingly, the more money it was losing the higher its stock price rose. It was trading at 10x revenues and even though the price has dropped into the fifties, it is still trading at 5x revenues.
“We currently see several pockets of opportunity in technology to find companies that have structurally flawed business models that will never make money and are, in fact, burning through a lot of money as rates slowly rise. As the equity risk premium increases, the cost of equity rises too.
“On the other side of the spectrum, we are also looking at low growth companies that have the potential to transition to declining growth. There are a lot of cyclical companies that can swing quite meaningfully and if you lay on the debt component as well that can lead to significant changes in market valuations.
“So we’re taking a bar-bell approach: companies where growth targets may never be hit and companies which are moving from low growth to no or declining growth.”
Spruce Point tends to be more bottom-up than top-down but having said that, from time to time the investment team looks at the wider macro picture, with Axler adding: “If we can find industries under more pressure than others, it makes the shorting component easier: especially if you have an industry under pressure and a company within that industry which is being fast and lose with its financial numbers. It’s always easier if we can overlay a weak company with a weak industry sector.”
Shorts are, by their nature, always going to be more trading-oriented because they are a riskier part of the portfolio. At Copernicus, short opportunities have increased although Rende confirms that the book currently has a low net short exposure. In his view, it is important to know not only when to put on short positions but also to know when to take them off.
“Various studies have shown that portfolio managers are good at putting on positions but they’re pretty bad and taking them off. It’s an important characteristic of my portfolio and how I view short opportunities. I’ve done this long enough to hopefully limit the cognitive bias in respect to how I think about putting on short trade positions.
“If I look ahead for US healthcare in 2019, I’m optimistic, particularly for cash flow-driven businesses that can take advantage of the large wave of financing that has taken place in biotech. Approximately USD81 billion was raised last year in biotech (from IPOs, secondary offerings and venture capital). That was the third largest year in history. The companies that benefit the most from that, broadly, are those in the instruments and tools space supplying US laboratories,” argues Rende.
As opposed to making a single bet in the biotech space, being invested in the wider tools and instruments space is a more diversified, lower risk way “to capitalise on the wave of financing we’ve seen over the last 12 months”, he says.
US hedge funds have the possibility to make serious returns for their investors if 2019 ends up becoming a higher volatility regime, favouring those with the stock picking skills of Spruce Point and Copernicus. Shorter-term tactical trading could well end up working to managers’ advantage, relative to passive long-only strategies.
As Bloomberg reported, one of the original ‘big name’ hedge fund managers, Paul Tudor Jones, founder and CIO of Tudor Investment Corp, believes 2019 might be a better time to be a trader than to just hold. “I don’t know if we’re going to have a huge amount of trends. It could just be an enormously volatile period with a lot of back and forth,” he said.
“I tend to agree,” Cavanna tells Hedgeweek in conclusion. “The last 10 years you could have just tilted your book 80 per cent net long, charged 2/20 and look like a genius. Those days are over.”
