Hedge Funds: Investment Themes for the Crisis and Beyond
Jamie Kramer: Welcome to the Center for Investment Excellence, a production of JP Morgan Asset Management. The center for investment excellence is an audio podcast that provides educational insights across asset classes and investment themes.
Today's episode on hedge funds has been recorded for institutional and professional investors. I'm Jamie Kramer, head of Alternative Solutions Group and guest host of the Center for Investment Excellence. With me today is Paul Zummo, Chief Investment Officer at JP Morgan Alternative Asset Management and Rich Bersch, Head of Relative Value and Macro Opportunistic Research. Rich, Paul, welcome to the Center for Investment Excellence.
Man: Thanks for having me.
Man Two: Glad to be here.
Jamie Kramer: For listeners who missed the most recent episode of the Center for Investment Excellence podcast channel, we will focus on the current market volatility, the impact of various asset classes, and how investors can best position themselves to withstand both current and future market conditions. Today will be discussing hedge funds, exploring how COVID-19 and market volatility are impacting the asset class.
Paul, congratulations. Last week you celebrated the 25th anniversary of your founding of JP Morgan Alternative Asset Management. That's one of the longest track records in the hedge fund space and a successful one with Sharpe ratios greater than one. These are the times that truly demonstrate the value of experience. JP Morgan Alternative Asset Management has managed this crisis so far with portfolios flat to slightly down versus equity markets down 20 to 30%.
Over the 25 years, there have been three major crises -- long-term capital management, the tech bubble, the global financial crisis, and now COVID-19. Paul and Rich, there are similarities and differences from each of these crises across drivers, magnitude, speed, and opportunities that arise. Can you share any lessons that may apply to all? Paul, let's start with you.
Paul Zummo: Sounds good. From my perspective, there's more similarities than differences or perhaps what's most different about each is the catalyst that causes the undoing and also in this case definitely the speed of the sell-off. But the underlying issues that fuel the crisis are often really the same -- so specifically leverage, illiquidity, and investor complacency.
Regarding lessons though or I would actually say they're reminders because they happen time and time again, a number come to mind and I'll throw out a couple. So first trees don't grow to the sky. Whether it's incident valuations during the dot.com era or more recently investors' unquenchable thirst for yield, excesses inevitably are created and ultimately they collapse. So it's critical to be disciplined.
And second, as far as hedge fund investing is concerned, manager risk is paramount. We're seeing material dispersion across different hedge funds, different hedge fund strategies, and it's a good reminder deep due diligence is always critical and necessary for success. Rich, you want to add anything?
Rich Bersch: Yes. I would add a couple. First, you know, tail events happen right. We don't design portfolios to live in the tail but we also want to consider the impact when that tail event inevitably occurs. It's all about constructing a well-balanced portfolio to perform in all environments and to be aware of what environment we're in -- not to fall prey to the typical temptations that everyone feels when we are late cycle.
And so it's not really just about playing defense -- it's about playing offense but you need to stay liquid and in the game when you're in a late-cycle environment when markets inevitably dislocate.
Jamie Kramer: Okay. So in keeping with the playing offense, pre-COVID you came into the year excited about three teams across the hedge fund landscape that seemed most compelling from your perspective. The first was quantitative investing and specifically statistical arbitrage including managers of the machine learning focus.
Rich, I think you're pretty smart but I'm pretty sure you didn't foresee the situation we would find ourselves in today. Can you walk us through how quant has done and most importantly is the steam still valid?
Rich Bersch: Well, on the last point first yes. I mean, the theme is definitely still valid. And you're right -- it wasn't driven by expectations of what just happened over the last several weeks. It was driven by certain very large-scale technological advancements and trends which are continuing today. You know, those trends are in kind of computing power and the cost of computing power, the availability of data, and the rapid and significant advancements in artificial intelligence and machine learning techniques.
That being said, one of the benefits of those Ai and machine learning techniques is the fact that they are adaptive. So while we didn't call this environment, I would say that the idea that this environment could happen is something that leads us to believe that machine learning systems should be able to pick up on the trends and the patterns that have existed in the past and are playing out again now.
That last point is really important because more traditional approaches in quant investing establish a set of rules upfront by which the market is expected to abide. The artificial intelligence machine learning approach allows for systems to figure out the rules and patterns by which the market is behaving on the fly. So it allows systems to be more adaptive to the investment environment than those traditional quantitative approaches.
So in March, on the whole, we saw shorter horizon systems adapt more quickly than those with slightly longer horizons. But as of today our manager systems have adapted and are generating positive results.
Jamie Kramer: Great.
Rich Bersch: If I tie that back to the comment I made before about making sure that we are kind of aware that tails can happen, the way we think about creating a portfolio in quant is to diversify by horizon, by market, by asset class such that those collective portfolios of quantitative systems perform across all environments including the ones we just went through.
Most relative value strategies, including quant, will suffer when markets are super volatile. When the volatility is very high, which was what we saw in March and periods like August 07, but they perform absolutely best in the periods immediately following when volatility remains high but is stable. And we see the spreads in relative value relationships kind of normalize. So that's why we're excited about these strategies really going forward.
Jamie Kramer: Great. Thanks, Rich. Paul, the second theme that you highlighted was long-short equities and specifically you are excited about opportunities in tech, telco, and healthcare. How has this theme performed and do you still like this area today?
Paul Zummo: So when I look at March we're definitely pleased with the performance of our low net exposure long-short equity management especially in the sectors that you mentioned. And it definitely continues to be a core theme of ours.
That being said, at this stage the equity markets rallied, you know, 20% plus from the bottom and in my opinion it's not an obvious screen and buy at this point. So while we're excited about the prospects for long-short equities, I think we're most excited about the alpha environment. Broadcast. What gives us that confidence is probably the question. Three things are really supportive to it.
So first if you look across the industry, gross exposure is quite low on the industry as a whole without being long-short. That sets up for a positive kind of supported flow environment. Second, the material sell-off call is stock correlations to sharply increase and conversely as that correlation falls -- as the market stabilizes -- stock pickers would be rewarded. And third, opportunities on the short side should improve going forward -- especially this kind of leverage and financing cost comes to center stage and that oftentimes pressures the weaker companies in the space.
Jamie Kramer: So long-short net exposure you like specific managers with alpha, with now low correlations and opportunities on the short side -- not the category overall.
Paul Zummo: You got it.
Jamie Kramer: Okay. So Paul, sticking with you one of our passions was your third theme of opportunities going into 2020 and that's sustainability. So a question for you is how has sustainability held up year-to-date and does COVID-19 accelerate the importance of ESG factors in hedge fund investing or does it sideline it a little bit at this point?
Paul Zummo: Sure. Great question. So on the performance front sustainability-focused portfolio you know, has definitely done well year to date. And I kind of highlight March as a month in which the sustainable leaning portfolio definitely outperformed the broader market index.
Now, energy -- specifically the steep decline in oil prices -- during the month was definitely part of the story. But even if you look more broadly, sustainable factors generally outperformed across most other sectors as well. So it has worked. And more importantly, as we come out of the crisis, I think we're going to find that the enthusiasm for sustainability will be stronger than ever.
And specifically, you know, obviously there are important environmental issues and that will continue to be in focus. But I think the crisis has really highlighted other focal points as well. Just to maybe throw out a few, the broader access to healthcare, technology plus sustainability, a need to address inequality, and the importance of governance in financial markets. I think everyone appreciated them before. I think the appreciation has risen dramatically as a result of the crisis.
Jamie Kramer: I would agree with you. March definitely tested the merits of each of our 2020 themes. And I would say that each of them proved themselves pretty well so far in the crisis. Congratulations again.
Rich Bersch: Yes, there was actually one other area that we were high condition but this one was more on the underweight side.
Jamie Kramer: Okay.
Rich Bersch: Anyone who has seen our heat map over the course of the last couple of years would know that we have been particularly bearish on liquid credit and distress credit. And that's something that we've been underweight in the portfolios and it served us extremely well in March. And at this point, we think the stage is set really for a multi-year opportunity in credit.
Jamie Kramer: It's not just what you owned and what you were overweight -- it's also what you were underweight. So that's a good point, Rich.
And then I think that's also a good transition into the opportunities. Looking ahead beyond the three that you talked about, what themes have emerged as a result of the volatility?
Rich Bersch: Well there's one thing that we see it happen really systematically after each crisis. And because we have strong relationships with our managers, it's something that we're generally able to take advantage of. That's an opportunity that's happening right now. And that is that some managers that have been closed for long periods of time who see the opportunity set kind of evolving in a very attractive way are open up or at least doing limited openings for clients like ourselves who have been invested with them for long periods of time.
So a great example of this is DE Shaw that did a very limited reopening over the course of the last few weeks with very little notice to investors. And we're seeing that really more broadly as well.
Jamie Kramer: So your existing investors are able to take advantage of that capacity. That's great. So moving on, Rich you had mentioned credit. Paul, can you please talk about or share with us obviously you have been very vocal about the complex staying underweight credit for the last two years. In fact, I think you could have said would have hated credit. And many of the consultants even commented on the fact that we were underweight credit versus many of our competitors.
Obviously credit has gotten hit here. Where if any in the credit market are you finding attractive opportunities?
Paul Zummo: Sure. And it is a different world in terms of what's going on now. And I expect the opportunity in credit to really be substantial across both structured credit and specifically in corporate distress. And maybe I'll kind of take each of them quickly.
So on the structured credit side, I mean we've seen enormous foresee leveraging with prices falling for both really fundamental as well as technical reasons. And initially that presented an excellent opportunity in investment-grade (CLLs) as an example and other kind of senior securities.
At this stage though while one still needs to be selective, we are confident that there are still a lot to play out in structured credit and it will continue to present opportunities for a very long time.
And then kind of switching to the corporate side and just to set the stage I mean there's been an enormous increase in the size of the credit markets over the years. And in corporate credit you know, the crisis has taken a toll on it as well. So today if you look in the market, about a quarter of high yield and leveraged loans are trading at distressed prices. And as we look forward you know, defaults will inevitably arise -- perhaps to the 8 to 10% range, which creates great supply. And that default rate is much higher than what we've seen for some time.
So kind of taking that together, it really sets up for a great opportunity set not only in secondary paper but also opportunities in rescue financing and kind of hands-on restructuring through the bankruptcy process. So we're definitely moving capital into the space.
Rich Bersch: And I think that Paul mentioned that it will take time to fully play out over time -- what we're seeing in credit and structure credit. And I think it's important to remember that the very rapid selloff we saw throughout March really is driven by investment fears of how those fundamentals will play out. And as a result, some of the dislocation is probably technical and some of it is fundamental. But the fundamentals will take longer to play out.
So a very good way to access the opportunity set at least in the immediate term is more on the technical side -- looking at technical dislocations without taking necessarily the market risk of trying to call a bottom in credit or call a bottom in equities. So on these technical dislocations, we're really seeing opportunities across a lot of relative value things including on the (CLO) side. Looking instead of at just buying CLOs you can go long CLOs and short high yield and create a relative value basket.
And the same is true in things like relative value trades in the mortgage markets, certain index arbitrage trades, merger arbitrage spreads, some opportunities in (SPAX) and certain basis trades like in the immunity market and other areas of the fixed income market. So really we're seeing a lot of these more technical dislocations that are very interesting in the immediate term.
Jamie Kramer: Well thanks Paul and Rich for sharing your insights and your high-conviction themes for investing through the crisis and beyond. To review, you began the year with three key themes on the overweight side -- quant, long-short equities, and sustainability. These have held up well and you believe that for the most part they should continue to outperform.
We then reviewed three actionable items as a result of the crisis, the first being finding attractive scarce manager capacity, the second being taking advantage of technical dislocation, and the third an abundance of opportunity now throughout the credit market.
In closing, we hope you, your families, your colleagues and constituents are successfully coping with the dramatic changes around the world. And we hope these insights make a meaningful impact on your investment success. Thank you Rich and Paul for joining me on the Center for Investment Excellence.
Rich Bersch: Thanks for having us.
Paul Zummo: It was great to be here.
Jamie Kramer: Thank you for joining us today on JP Morgan Center of Investment Excellence. CFA Institute members are encouraged to self-document their continuing professional development activities in their online CE tracker. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our website. Recorded on April 9th, 2020.
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