Alternative Investments Insights

May to August 2018

Friday, 10/05/2018

Since the beginning of the year, the hedge fund industry has successfully navigated a complex environment, while most asset classes have suffered.

Friday, 10/05/2018 - 08:00
Cedric Vuignier Alternative Investments Expert
Christophe Campana Senior Analyst
  • Core equity markets were finally resilient between May and August.
  • CTAs were able to lock in gains as emerging makets sold off.
  • Volatility normalisation is taking more time than expected to settle.
  • The trade war between the US and China weighed on large mergers.
  • Dispersion of returns across managers and strategies is rising.
Grille d'allocation

THE SITUATION SO FAR

What a year, thanks to Donald Trump. Hedge funds seeking volatility finally got what they wanted this spring as a range of events weighed on markets, including trade wars, political tensions in Turkey, and Trump’s approach to currency and interest rates. This volatility and the uncertainty it created benefited dedicated hedge funds strategies, such as fixed income arbitrage, while equity beta-driven strategies suffered. US long/short equity strategies focusing on healthcare and technology were less impacted and capitalised on the strong rallies in their respective sectors. Others, such as merger arbitrage strategies, were directly hit by Trump’s actions. The $44bn Qualcomm-NXP merger is a great example of casualties resulting from US-China trade tensions. Overall, return dispersion across strategies and managers was important and so was the emphasis on selection.

Since the beginning of the year, the hedge fund industry has successfully navigated a complex environment, while most asset classes suffered, with the exception of the US equity market. Notably, risk parity and multi-factor risk premia strategies, which had raised massive assets in recent years, struggled as well. We believe the opportunity set for hedge funds is growing. Short-term US interest rates are rising, realised volatility is exiting years of lethargy and markets are more fundamentals-driven, as witnessed by the improving intra-stock dispersion. While it is too early to firmly call, it seems we are finally heading toward a pre-2008 crisis framework.

MACRO

The review period was quite uneventful for discretionary macro managers unable or unwilling to implement risk, paralysed by the lack of market clarity. We once again witnessed conflicting forces as rising inflation and further rates hikes in the US were offset by political stress in Italy and then turmoil in Turkey. As such, performance was flat to negative, with the exception of some managers who were able to capitalise on emerging market stress – a stress driven by US strength rather than EM weakness. Overall, positioning was light, with no real consensus except on the lack of manager conviction. Increasing expectations the Bank of Japan might change its monetary policy could be bearish for US bonds, as anchored yen rates have been a force keeping global core rates from moving too high too fast. Similar to discretionary managers, systematic managers struggled, although they benefited from more sustainable trends in August on the back of the EM sell-off and were able to keep portfolios tilted towards equities and commodities.

Our outlook

Top-down macro rate trades are coming back as some historical discretionary managers are starting to raise assets and perform well after years of disappointment. Higher real rates and strong growth in the US acted as the catalysts for this. We reiterate our positive outlook for macro, but with a preference for relative value strategies over directional ones.

EM Real Rates Still Have a Cushion versus the US
EM Real Rates Still Have a Cushion versus the US
Source
Bloomberg, Haver Analytics, Morgan Stanley Research. Data as of: 31.08.2018

EQUITY HEDGE

Equity markets finally became resilient between May and August – a period ripe with tensions, as previously indicated – with European equity markets staying flat underperforming US markets. Worldwide, healthcare and IT sectors led markets, thanks to the visibility and strength in earnings. In aggregate, equity long/short managers did pretty well thanks to sustainable trends in selected growth sectors – such as IT and consumer cyclicals – including in FAANG stocks. However, we saw wide dispersion among funds, with value stocks coming under pressure after the imposition of tariffs on Chinese imports, which impacted industrials, energy and materials sectors. Emerging markets managers had a hard time as most of them have a structural long bias and key markets such as Brazil, China and Turkey weighed on performance. In regards to Chinese long/short managers, some were hurt by a substantial net long exposure in the consumer discretionaries and materials sectors. In regards to equity market neutral strategies, results were mixed, the main cause of this being the reversal in momentum and value equity premia we saw in June.

Our outlook

Sector dispersion kept rising, with leading industries such as IT, consumer discretionaries and healthcare outperforming while telecoms, consumer staples and basic materials lagged. We still favour managers with low or flexible net exposures in a constrained investment universe to mitigate any sharp sector rotations. A shift towards more defensive sectors cannot be excluded at this point in the economic cycle.

The gap between Value and Growth has not been that wide since December 2016 in the US
The gap between Value and Growth has not been that wide since December 2016 in the US
Source
SYZ Asset Management, Bloomberg. Data as of: 31.08.2018

EVENT DRIVEN

The strategy posted positive performances during the period with huge dispersion in fund returns year-to-date. Returns were once again primarily driven by the success of corporate actions. Merger arbitrage did quite well, although the typical bottom-up process-driven analysis was challenged by politics. It was certainly a difficult sub-strategy for the managers implementing cross-border trades, due to the ongoing US-China trade war – with China holding merger and acquisition approvals hostage to reciprocate against increased US tariffs. Special situation funds were a bit choppy as well, while activism led the pack, helped by the positive performance of US equity markets. Indeed, most activist situations unfold in the US, even if a number of peers have emerged in recent years in other regions. Credit event-driven remained a relatively muted area with benign default rates and primary markets wide open.

Our outlook

With politics driving the success of a number of large cross-border corporate actions, it makes sense from an expected return point of view to invest in smaller funds, which typically focus on mid and small capitalisations. With rising tensions in a number of countries currently, focusing on liquid securities is also important.

M&A volumes in USD
M&A volumes in USD
Source
Bloomberg. Data as of: 31.08.2018

RELATIVE VALUE

After the volatility spike of February, many were expecting a fundamental change which did not materialise, as implied and realised volatility fell back to low levels and investors dismissed a potential market correction. Credit long/short managers reiterated their defensive positioning on the back of tight spreads and liquidity issues. Nonetheless, the review period saw crude oil surge as Trump’s administration denounced the Iran nuclear agreement, thus allowing the energy complex to rally. This was short-dated as the emerging markets sell-off put credit under pressure. Overall positioning was idiosyncratic with some major recurring themes, especially across stubs and distressed. With regards to fixed income and volatility arbitrages, the picture stayed positive with managers charging full speed ahead, diversifying risk away from the recurring German basis trade in favour of the US and Japan. The VIX curve saw sharp intra-month moves, which were difficult to navigate for volatility premium arbitrageurs. Other volatility managers were severely hit by the BTP sell-off in May, with the opposite leg unable to offset losses as the risk did not spread to other zones or to equities.

Our outlook

We are maintaining our positive outlook for rates and volatility arbitrageurs while staying cautious on capital arbitrage managers that have trimmed allocation to convertibles in aggregate – despite marginally increasing exposure to them in Japan.

Russell 2000 implied volatility near an all-time low
Russell 2000 implied volatility near an all-time low
Source
Goldman Sachs Global Investment Research, Goldman Sachs Group Inc. Data as of: 31.08.2018

OUR CONVICTIONS

Merger arbitrage made the news in recent months as a few high profile acquisitions did not complete successfully. As evidence points to the lack of knowledge of market participants, the below paragraphs highlight some strategy basics and detail one transaction which hit the headlines recently and is likely to drive certain fund performances over the coming months.

Most merger arbitrageurs try to exploit the difference between the acquisition price and the price the target’s stock is trading at before the completion of the merger. This is called the ‘spread’. Spreads typically vary according to a number of parameters, including M&A volumes, capital in the strategy, risk tolerance/aversion, perceived quality of pending transactions and interest rates. It also depends on the ability to enforce merger agreements, which itself depends on the law. Even strong deals can break, but the legal system in stable jurisdictions can provide some support for investors allowed to keep a position after a deal breaks. Understanding merger agreements and precedents in key jurisdictions constitutes an edge for sophisticated hedge fund managers, though it does not guarantee success. With regards to risks at the level of a merger arbitrage fund, just like in any investment strategy, leverage and diversification are useful measures. Only a minority of single-strategy funds have a long market value in excess of 300% of NAV. Most cap risks at the transaction level through a maximum estimated loss should the transaction break, or simply through a maximum long market value exposure to any one transaction.

Let us study a specific case. In April 2017, Fresenius, a European healthcare company, announced it had signed an agreement to acquire Akorn, a US company incorporated in Delaware. In April 2018, Fresenius announced it was terminating the merger agreement. Fresenius found integrity breaches – deemed material – in data Akorn provided to the US Food and Drug Administration. Akorn then filed a complaint in court requesting the judge enforce the closing of the transaction. The trial started in July 2018. In the absence of a private settlement ahead of the ruling, fund managers are studying precedents, briefs of oral hearings, as well as the merger agreement to decide whether the Delaware judge will allow the transaction to break, based on a Material Adverse Change. The most likely outcomes comprise an enforcement of the transaction, which would drive Akorn’s share price to its deal value of $34 per share, or a confirmation of the break, which would drive Akorn’s share price back to its fundamental value – estimated at an upper single digit. Diversifying portfolios is key when facing such binary and complex outcomes.

Akorn share price in USD
Akorn share price in USD
Source
Bloomberg. Data as of: 31.08.2018