The hedge fund industry was able to take advantage of the bullish trend in all risky assets in the first quarter of 2013, says a new report from Natixis. Investors remained in a risk-on mode (the S&P 500 was up 10%) despite the combination of several risk factors, in particular 1/ the fears of automatic government spending cuts (sequestration) in the United States; 2/ the Italian elections and the ensuing political crisis; 3/ the unprecedented nature of the Cypriot bank bailout plan (involvement of depositors). Further details from the report below Natixis.
All in all, the industry reported good performances just like the non-investable HFRI and Dow Jones Credit Suisse indices that were up 3.8% and 3.6%, respectively, in Q1 2013. By the way, they have both hit new all-time highs in the past few months, indicating that many funds have now returned to their high watermarks. More specifically, all strategies, apart from Short Sellers and Merger Arbitrage, posted a quarterly performance in excess of 2%. The long equity bias strategies even showed a performance in excess of 4% (5.1% and 4.5%, respectively, for Long/Short and Emerging). Assets under management continued their upward trend, reaching an amount of USD 2,128 billion as of 31 December 2012, i.e. up 5% year-on-year (including CTAs, excluding funds of funds). This mainly reflects the performances of the industry, as a certain amount of withdrawals was recorded during the year.
Towards a return of idiosyncratic risk?
As we expected at the beginning of the year1, the high risk concentration that has characterized the post-crisis years eased during the first quarter of 2013. Despite the resurgence of political risks, our indicator has stabilised below 55% (Chart 3), indicating that asset valuation is now more a function of fundamentals specific to each market than of overall fluctuations in risk-on/risk off.
This phenomenon is partly explained by an analysis of the change in the macroeconomic consensus in the major economies (Chart 4): forecasts of growth and inflation are being revised upwards, e.g. in Japan and the United States, but downwards in India and the euro zone. As for the United Kingdom and Brazil, inflation is being revised upwards while growth is being revised downwards. Accordingly, this diversity in sentiment regarding the largest economies makes it impossible to identify a marked trend that could fuel an across-the-board move (upwards or downwards) in risky markets.
So we are seeing certain trend breaks in correlations, as for example between emerging sovereign bonds and High Yield corporate bonds. These two assets have historically been closely linked as they are heavily influenced by investor risk appetite/aversion. However, since the start of the year, the characteristics specific to each market seem to have prevailed emerging spreads have been widening under the impact of a mixed news flow in Asia and Latin America, while European High Yield continues to boast good performances given the current quest for yield, underpinned by still very low default rates.
A second concrete illustration of this return to fundamentals is given by the divergence between the performances of commodities and stock markets, which became even more pronounced during the last quarter. Over the first three months of the year, the oil price hardly rose – particularly influenced by Saudi Arabia’s change of policy (Saudi officials would apparently be happy with an oil price of around USD 100) and the mixed signals from emerging economies – while the S&P 500 was up 10%. The first weeks of April confirmed this tendency, given the fall in most commodities and the resilience of stock markets.
We have carried out a more detailed analysis of the impact of these developments on the performances of the different strategies.
Profitable geographical arbitrages for Global Macro, Fixed Income and CTAs
Global Macro and Fixed Income Arbitrage were among the least good performers in the first quarter, but nevertheless posted a performance of 2.2%. Global Macro strategies were able to take advantage of the stock market rally, particularly in the United States and Japan. The best performers thus increased their exposure to Japan via the smallest caps, which outperformed the benchmark index. These positions did very well at the beginning of Q2 given the switch into equities by many yield-hungry Japanese investors. We believe that Global Macro managers will continue to take advantage of the disparities between the performances of developed and emerging stock markets during the next quarter.
The best Fixed Income Arbitrage managers switched their portfolios to risk-on mode by increasing their exposures to High Yield. At the same time, they anticipated the underperformance of emerging economies and successfully bet on the spread widening that has indeed taken place since the start of the year.
Lastly, CTAs started this year in a better fashion than they finished 2012, with a positive performance of 3.7%. They primarily benefited from their preference for US equities and their short position in JPY. The less good performers kept – or even increased – their exposure to commodities and more particularly precious metals. Given the selloff in this market, we are concerned about these managers’ performances for April, assuming that they have not changed this positioning. However, the increased volatility in exchange rates and commodities is likely to benefit CTA funds as a whole.
Equity funds: In the absence of a major trend, give preference to arbitrage funds
Long/Short Equity funds, which on average increased their long exposure to the main stock markets in Q1, came in at the top of the ranking of performances by strategy, at 5.1%. They were lifted by the rally in developed stock markets during the quarter: +10% for the S&P 500, +5% for the Stoxx and +19% for the Nikkei. The potential for a further rise by the end of the year is still significant for the US index (our objective is 1,680 points), reinforced by the short-term correction, whereas the rise in European indices is likely to remain more muted (objective for the Stoxx is 300 points). So the Long/Short Equity funds exposed to the US growth theme should still be favoured, while the growth drivers are very limited in the euro zone (0.7% contraction in GDP in 2013 versus 1.6% growth in the United States). Despite the disappointing trajectory of emerging stock markets (-2% quarter-on-quarter for the MSCI EM), related to the correction in commodities and the lack of signals of an acceleration in the Chinese economy, Emerging-style funds posted a nice performance (+4.5% in Q1). The best managers were able to adjust their geographical allocation in an opportunistic manner by tactically increasing their exposure to US and developed Asian equities.
While Equity Market Neutral posted a performance of only +2.4% this quarter, after a quite poor 2012 (+3%), we believe that the factors indicating a return to favour are now in place and we therefore remain confident about their potential for outperformance in 2013. The risk-off/risk-on phenomenon that has characterised these past years, notably illustrated by the across-the-board increase in inter- and intra-asset class correlations, has taken its toll on the arbitrage strategies used by Market Neutral funds2.
An analysis of the distribution of their overall exposure to equities (market beta, according to the CAPM) confirms the hedging problems encountered by Equity Market Neutral managers in the recent period. While the majority of managers managed to maintain a low overall exposure to equities during the initial period from June 2005 to June 2008 (beta clustered around 0, relatively standardised distribution), we see a far more pronounced long exposure in the recent period. In particular, the bimodal distribution that appears in the second Chart illustrates a certain segmentation within the Equity Market Neutral strategy over the second period, with a first group of funds that has fulfilled its mandate by maintaining a beta of zero or almost at the market, and a second group that has not succeeded or has deliberately increased its exposure to improve its performances (and therefore, as a result, its risk). The shift to a more favourable environment for intra-class arbitrages, as described above, will, logically, first and foremost benefit Market Neutral strategies.
We therefore believe this configuration is rather favourable for alternative management in the sense that the managers should have the possibility to generate alpha from this greater dispersion i/ between asset classes in the case of directional strategies and ii/ within asset classes for arbitrage strategies. We therefore expect alternative management to outperform traditional management, which could then trigger a rebound in inflows in 2013.
