Hedge funds outlook : Change and opportunity
While 2023 will have its share of forbidding terrain ahead, we also see it as a year of change and opportunity.
While the worst of the market sell-off may be behind us, there is still significant economic and market uncertainty to come in the year ahead. With this volatile and challenging backdrop, hedge funds are positioned to continue to add significant value to investors' portfolios through alpha, inflation protection and dislocation opportunities.
By many measures, 2022 was a challenging journey for investors. As the year unfolded, public markets suffered significant drawdowns and, unusually, public equities and fixed income were correlated to one another. Hedge funds proved critical in delivering alpha and diversification in this environment when portfolios needed it most.
While 2023 will have its share of forbidding terrain ahead, we also see it as a year of change and opportunity. Persistently high inflation, higher rates and elevated volatility are creating an investment landscape quite unlike any we have faced in decades. In order to navigate this new environment, investors will need a new toolkit to provide the “AID” that portfolios require: alpha, inflation protection and dislocation opportunities. Fortunately, hedge funds can deliver on all fronts and arm portfolios for the risks and opportunities ahead.
In this new environment, active management – through selecting strategies and managers – will be key to producing enhanced returns and implementing hedge fund portfolios. Expertise is required to be able to identify, execute and monitor these portfolios and is an ever-evolving mission. In our outlook, we outline a roadmap of our highest conviction hedge fund strategies that we believe can generate uncorrelated alpha, navigate inflation and interest rate induced volatility and capitalize on near-term market dislocations.
Looking back on 2022, there was no shortage of drama across global financial markets. In an effort to curb rampant inflation, we saw central banks globally increase policy rates at the fastest pace on record. This induced a large simultaneous reset in valuations across both equity and fixed income markets. In fact, 2022 was the first time in more than 150 years that stocks and bonds were both down at least 10%. Markets remained highly volatile throughout the year as we witnessed wild swings on both the up and downside. The average monthly move for the S&P 500 over the year was nearly 6% – the third highest monthly average for a given year since 1950.
With the typical 60/40 portfolio down -16% on the year, investors had very few places to hide – though our hedge fund portfolios were one of them. Aided by the decline in markets and the elevated level of volatility, our platform delivered its biggest positive outperformance in 2022 (vs. traditional markets) since the Global Financial Crisis of 2008-2009. Given the very uncertain outlook coming into the year, our portfolios were tilted heavily toward trading-oriented and convex strategies – like Relative Value and Macro – which we felt could withstand any major market sell-offs while also benefiting from the ongoing elevated volatility. We entered the year with below-average allocations in directional equity and credit strategies given the challenging backdrop for risk assets and the beta embedded in many of those strategies. Those views proved correct and our clients were rewarded across portfolios. Our uncorrelated hedge fund portfolios posted gains in 10 of the 12 months in 2022 to end the year up approximately 6%. Other than Macro, quant hedge fund strategies were the other major beneficiaries of cross-asset volatility. Overall, our Quant portfolios ended the year at +8% with limited drawdowns throughout the year.
Looking ahead, we believe it will continue to be a challenging investment environment for many traditional assets. While inflation has likely peaked in the U.S., the path of reducing inflation to the Fed’s target while not causing a recession appears quite narrow. As such, we suspect that inflation and, related, interest rate expectations will likely prove too optimistic in the near term. Additionally, and despite the steep sell-off in 2022, equities and – especially – credit are not “cheap” and arguably do not reflect the likelihood of earnings revisions and future defaults. Taken together, we expect ongoing market uncertainty and volatility, which should benefit alpha investors. And, while we remain underweight in equities and credit, we are finding compelling idiosyncratic opportunities and expect to increase our exposure as we progress through the year, especially if additional repricing/dislocation arises.
In 2023, we believe that an alpha-focused hedge fund allocation will continue to be additive to multi-asset portfolios. Entering the year, we maintain our overweight in less correlated Relative Value and Macro strategies, which should continue to benefit from above-average levels of cross-asset volatility. We continue to maintain our underweight in Long/Short Equity, though we see select opportunities in dislocated areas like biotech and China. Broadly speaking, hedge fund managers remain defensively positioned going into the new year, and we expect them to continue to be very tactical and responsive to near-term market movements.
The quarterly strategy heatmap is integral to our portfolio construction process. It guides our portfolio allocations and represents our conviction in different strategies over the next year, albeit with a focus on the near term.
Our “balanced” portfolio weights are: Relative Value: 39.5% (44.5%), Opportunistic/Macro: 27.5% (20.0%), Long Short Equity: 20.0% (21.5%), Merger Arb/Event Driven: 2.5% (4.0%) and Credit: 10.5% (10.0%). Figures in parentheses indicate the weights from a year ago, where the change is driven by top-down views from our quarterly strategy heatmap and by bottom-up analysis from our manager selection and due diligence process.
JPMAAM Quarterly Strategy Heatmap
With continued economic and political uncertainty, volatility should remain relatively elevated, creating a robust opportunity set for most Relative Value strategies.
Both short- and medium-horizon quant strategies should continue to do well given that we expect periods of higher volatility as markets look for a new equilibrium in a recessionary environment. These computer-driven strategies are designed to generate an uncorrelated return stream from short-term mispricings across equities as well as futures, while seeking to limit market and factor beta. Our approach of using both traditional quant (prior-based alphas) as well as machine-learning funds has helped to create a more robust return stream.
Multi-strategy managers performed well in 2022 and continue to be well positioned to benefit from the market environment, as their flexible balance sheets should allow these funds to nimbly allocate capital across different opportunities as they arise. That said, the dispersion in manager performance is high and it is important to understand each fund’s distinct specialties and their ability to scale those capabilities.
Discretionary Macro was a standout performer in 2022. Short rates, long USD and long commodities were some of the key positions held by Macro managers that added value throughout the course of the year. Heading into 2023, there is less consensus among Discretionary Macro manager views, so we expect performance drivers to be less concentrated and more diversifying moving forward.
Despite our expectation of less obvious trends in the coming year, elevated volatility across asset classes and interest rates unhinged from the zero bound should pave the way for a continuation of the above-average environment for the strategy. We believe uncertainty on the macro and political front, along with divergent economic and policy stances across regions, should provide additional tailwinds for the strategy.
Additionally, range-bound markets with ample volatility should allow managers the ability to enter and exit trades more frequently, benefiting from both long and short expressions of the same themes. We continue to prefer managers who can express these views using instruments with convex return profiles.
On the Opportunistic front, reinsurance presents one of our most attractive investment opportunities and appears to be offering the best entry point in more than a decade. The dislocation is largely a function of supply/demand imbalance.
As illustrated in the following chart, the last five years have seen above-average catastrophic losses, leading to an erosion of capital for rated reinsurers and disappointing returns for investors. More recently, capital allocators have also been saddled with meaningful losses across their traditional (i.e., equities and fixed income) investment portfolios. This has resulted in a significant reduction in the available capital that can be supplied heading into the 2023 renewal season. Conversely, inflation and regulatory forces have put upward pressure on the notional amount of reinsurance required across the industry.
Combining these supply/demand factors, we expect premiums (and thus ex-ante returns) to increase by a magnitude of 25%-40% on a YOY basis. Further adding to the attractiveness of the strategy, catastrophe reinsurance is one of the few strategies where returns are not driven by financial markets, making it a very strong source of diversification away from equities and fixed income.
Guy Carpenter U.S. Property Catastrophe Reinsurance Rate on Line Index
Finally, we have increased conviction in faster-trading, shorter-horizon commodity trading advisors (CTAs) this quarter. CTAs in general performed very well last year due to persistent trends in equities, rates and currencies that drove ample trading opportunities across a number of futures markets. Purely trend-following strategies, which rely on persistent trends, can be vulnerable in reversals, and there is potential for shorter-horizon CTAs to do better in choppier markets. Additionally, we prefer to see breadth in terms of models (beyond trend-following) and markets traded.
Long Short Equity
Given inflationary and rate-related headwinds facing equities today, we remain underweight Long Short Equity strategies. That said, we anticipate increasing our market beta as the year progresses and believe that a combination of heightened dispersion, higher borrowing costs and a more skeptical market should prove beneficial for alpha opportunities, especially on the short side. Additionally, we have been leaning into select dislocations and deploying capital in biotechnology and Asia (with a focus on China). More broadly, we expect non-U.S. outperformance in 2023.
Biotech has experienced a historic drawdown, both in magnitude and duration. A silver lining is that post-drawdown returns have consistently been very strong historically. Given the materiality of the dislocation, we believe the market is ripe for active management. M&A and other innovative partnerships between big pharma and “beaten-down” biotech companies can create meaningful upside in specific names and generate significant dispersion within the sector. In the current environment of depressed capital markets, it is important to understand companies’ balance sheets, cash burn and ability to reach important milestones, such as completing a clinical trial or FDA approval.
Sentiment on Asia has improved dramatically now that China has relaxed its zero-COVID policies – albeit with a bumpy start – and is re-focusing on policies that aid economic growth, rather than rein in corporate excesses. That said, the road to recovery for China may not be a straight one given the challenging global growth backdrop. Thus, we continue to like a low net Long Short approach to investing in China.
Value-oriented Opportunities in Biotech and China
Merger Arb/Event Driven
We remain underweight Event Driven strategies given the overhangs from lower market valuations, difficult financing conditions and low CEO confidence. We expect limited deal/transaction volume in this environment and, thus, limited opportunities to earn attractive rates of return. Given the limited opportunity set, we prefer vetting and participating in individual co-investments in lieu of dedicated fund exposure.
A bright spot in the event space is the growing number of low-coupon, high yield-to-maturity convertible bonds. These structures have become largely orphaned as investors flock to attractive yields available in vanilla debt offerings. Event-oriented managers can create additional value in these structures by agitating for negotiated tenders, refinancings and other events.
We remain underweight credit overall given relatively tight spreads despite deteriorating economic conditions. While directional exposure remains very low, we have selectively taken advantage of the reset in interest rates by adding to yield-oriented strategies that offer attractive return potential in the current environment.
With respect to yield, we have been increasing exposure to structured credit in our portfolios. We have focused on opportunities with limited duration that offer structural protection in the event economic conditions worsen from here. Similarly, we have grown our allocation to niche loan origination strategies that have high barriers to entry and offer similar risk/return characteristics, such as structural protection, limited duration and higher yields.
We remain patient with respect to adding stressed/distressed exposure at this juncture and anticipate finding a better entry point in the coming year. In the meantime, we have been actively growing manager relationships to ensure our ability to scale quickly when the time comes. We anticipate Europe’s more dire economic situation could give way to a more meaningful opportunity set. As such, we remain focused on expanding our tool kit in the region during the early part of 2023. Irrespective of the region, we will look to partner with managers that can benefit from dispersion today, investing both long and short in the near term, and that can pivot toward long-biased distressed investments in the event of a significant dislocation.
In summary, while the worst of the market sell-off may be behind us, there is still significant economic and market uncertainty to come in the year ahead. With this volatile and challenging backdrop, hedge funds are positioned to continue to add significant value to investors’ portfolios through alpha, inflation protection and dislocation opportunities. We continue to look to Relative Value and Macro strategies to provide persistent uncorrelated returns and are selectively optimistic on dislocated thematic opportunities. Active management, through strategy and manager selection, will be imperative to implementing return-enhancing hedge fund portfolios.