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Time for active managers to prove their worth

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While hedge funds struggled in Q4, so did passive investments. Could higher volatility in 2019 help active stock pickers shine?

The fourth quarter of 2018 culminated in a substantial market correction. Everywhere one looked, it was a sea of red. Far from bringing festive cheer, on Christmas Eve both the Dow Jones and S&P 500 fell 2.5 per cent before a rapid rebound a couple of days later. 

At one point the Dow was down 18.8 per cent from its October high, while the S&P had fallen 19.8 per cent. 

Volatility is often the friend to hedge funds, historically, as market corrections are precisely when active managers can demonstrate their alpha generating capabilities; and by inference, not hide behind market beta in a trending bull market. 

But Q4 proved a challenge for hedge funds, with some high profile names enduring a terrible year. Indeed, the likes of Leon Cooperman’s Omega Capital decided enough was enough while funds such as Dan Loeb’s Third Point recorded losses of 6 per cent in December, as reported by CNBC.

“The Oct/Nov period for hedge funds, broadly speaking, was quite bad, particularly for those focused on the energy sector, financials and industrials,” says Jack Seibald (pictured), Global Co-Head of Cowen Prime Brokerage & Outsourced Trading. 

“What transpired in December, however, may have levelled the playing field. The fact is, long-only funds suffered sizable losses that were worse than those incurred by hedge funds. I think this market sell-off probably helped put hedge fund performance in Q4 into a clearer context from the investors’ perspective. If you look at the overall averages for hedge funds, relative to the broader markets, they came out of the year in not too terrible shape. 

“Returns were very bifurcated, however, so one should not generalise too much.”

The HFRI EH Fundamental Value Index ended December down -5.19 per cent, underscoring the challenges that active stock pickers faced in the market. Overall it was down -8.84 per cent. 

Looking more specifically, however, at sector-specific hedge funds, those in the healthcare and TMT space fared materially better. 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, whereas the HFRI Sector – Technology Index was up 3.84 per cent.

“Hedge fund managers in these two sectors were considerably ahead of most strategies for the year even with the difficult ending. Funds that were exposed to Asia and to emerging markets, on the other hand, were badly hurt,” says Seibald. 

Indeed, the MSCI Emerging Markets Index ended 2018 down -14.58 per cent.

“It was a tough period and there was a wide dispersion of results among hedge funds, but it certainly seems to me that relative to market averages, equity-centric hedge fund managers did not do as badly as I would have expected back in early December. 

“Among some of the larger established hedge funds, you saw some outrageously good performances as well as others that did terribly. Based on early results, it seems that there was a wide dispersion of performance, with fewer than typical returns hugging the mean; managers either called them right or wrong in 2018,” comments Seibald. 

What originally started as a rally that anticipated better times ahead because of deregulatory activity undertaken by the current administration, ended up creating an environment of higher earnings growth. Now the question is whether 2019 will continue to support strong earnings growth.

Back in September 2018, the S&P 500 was trading at a 16.5 multiple but by October that multiple had fallen to 15. CNBC reported on 24th October that whereas some think earnings growth will be 7 to 10 per cent, the markets are pricing in tighter earnings such that the growth figure might be half what the bulls think.

“The market appears to have concluded at the end of 2018 that the combination of the Fed’s activities, the US/China trade war, the US/Canada/Mexico trade dispute, and the US government stalemate that resulted in a shutdown, would result in a material slowdown in economic growth and therefore a headwind to earnings growth in 2019. Some market participants have even begun to talk about a decline in S&P earnings,” says Seibald.

“I’m not sure it’s that simple, however. Unless there’s a serious external shock, I just don’t see how you go from 3 per cent plus GDP growth to negative growth so quickly. I still think there are some lingering benefits from the relaxation of the regulatory environment and the tax changes that were introduced, but we will have to see whether that results in sustained capital investment. As it relates to monetary policy, it already seems that fewer rate hikes than previously anticipated by the Fed in 2019 are being more widely discussed. Though I’m not in the forecasting business, it seems to me that the conventional wisdom might be migrating to the notion that one might be enough if slower growth expectations are confirmed by economic data.”

Record earnings growth combined with the US stock markets falling in December led to a dramatic compression in market multiples. This has created specific investment opportunities for managers who focus on fundamental investing. “The groundwork has been laid for that opportunity in 2019, whether hedge fund managers capitalise on it remains to be seen,” comments Seibald. 

“All I kept hearing from market commentators throughout much of the back half of last year was that heading into 2019 you had to be invested in emerging markets because that’s where the value was relative to the US. After what happened in December, if you’d stayed in emerging markets, you would have gotten hurt just as bad, if not worse, than the US. 

“In the US energy sector valuations compressed materially as oil prices dropped. As a result, we’ve begun to increasingly hear the same relative value argument from market participants about 2019.” 

The meaningful increase in volatility during the last few months of 2018, though not unexpected or unprecedented, has put managers back on their heels. The volatility index spiked at 35.50 on 26th December 2018 and although markets have settled in January – the VIX is currently 17.80 – hedge fund managers would certainly welcome more volatility to prove their trading prowess to investors. 

“Overall, I am a somewhat less concerned about the outlook for hedge funds in 2019 than I might have been at the beginning of December. Most investors got hit hard, whether passive or active, so there shouldn’t be too much finger pointing at hedge funds. On a more constructive note, it seems that the increased market volatility we’re now experiencing ought to provide active managers another opportunity to assert themselves,” concludes Seibald.

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