David Lebovitz: Welcome to the Center for Investment Excellence.

Lynnette Ferguson: Thank you for having me.

David Lebovitz: It’s our pleasure. So today I want to spend a little bit of time talking about hedge funds. And hedge funds have had, you know, a bit of a tough run here over the course of the current cycle.

That said, you know, we’ve some macro-economic developments which haven’t necessarily led investors to feel terribly comfortable. But, you know, the kind of knock on effect of that is that this could actually be an environment that we are coming into where hedge funds begin to perform a bit better.

You know, it’s interesting because we came into this year and I think back to the end of last year sitting at my parent’s house on Christmas Eve and watching the bottom fall out of the stock market and my dad asking me, you know, “What’s wrong? What’s going on? It’s Christmas Eve you should be hanging out with your family not, you know, working on your iPad and your laptop at the same time.”

At that juncture like the bottom was falling out the stock market. The S&P 500 fell by nearly 20%. If you were looking for forecasts for growth to start 2019 they were in kind of the low single digits looking for like 1, sub-1 growth.

And then the first quarter came, the first quarter went. We have the longest government shutdown in U.S history and when all the numbers came through the door we actually saw that the U.S economy grew by 3% in the first quarter. That caught a lot of people by surprise.

And, you know, obviously the reasons for that 3% growth were a bit unique. It was primarily due to a better than expected contribution from trade and an inventory build which occurred at twice the historical pace.

But now we are into the second quarter and we are not necessarily feeling quite as confident about where things are headed. Obviously some of that boot to growth in the first quarter needs to be paid back in the second quarter.

But at the same time we’ve seen trade tensions which felt like they were kind of getting themselves under control begin to resurface. The rhetoric around the Fed has completely changed, you know, the sale-side was calling for a number of interest rate hikes at the end of last years. The sale-side is now in aggregate looking for interest rate cuts in 2019.

And that’s led us into an environment where volatility has picked up, uncertainty has increased and some of the things that we think may have held back hedge fund performance up until this point may be finally beginning to shift in another direction.

You know, from where I sit there are really three things that have impacted hedge fund performance negatively over the course of this cycle and it’s been - high correlations, low dispersions and low-volatility. So in other words the fact that everything in the equity market has been moving together the difference between the winners and the losers has been relatively narrow.

And relative to what we’ve seen on average overtime equity markets haven’t been quite as bouncy as perhaps they were in the past. And, you know, that environment has been challenging for active managers -- broadly has been challenging for hedge fund managers in particular. That’s really manifested itself in flow and performance dynamics.

I mean, three out of the past four years have seen negative net flows out of the hedge fund universe.

Thinking about the first quarter of this year, the U.S  equity market - sorry. The global equity market was up over 12%. The best performing hedge fund sector was up about 7½% and that was equity long/short.

And so I think a lot of people are sitting there asking themselves, you know, why would I pay an active management fee when I’m getting better performance from bid and I think that’s a fair question to ask.

But I also think that as volatility picks up correlations come down and dispersion begins to widen out, you know, the tide may turn for hedge funds broadly.

So Lynnette I would love to bring you into then conversation and talk a little bit about, you know, within the hedge fund universe there is this term that gets thrown around and used in relatively nebulous fashion. But within the hedge fund universe, you know, what are some of the issues that you’ve picked up on for specific types of strategies?

What are some of the headwinds that you think may have impacted performance up until this point, you know? And then later on in the conversation maybe we can move into where we are finding some opportunities at the current juncture.

Lynnette Ferguson: Okay. So I think you bring up a lot of really good points with me very focused on in terms of looking at hedge fund strategies how I see it here at JP Morgan. In I think maybe, you know, comments in terms of the Fed, in terms of general correlation, dispersion more recent as well as that of last year actually may be a point to kind of come to.

And maybe actually initially what might be interesting just to comment on is actually that it’s been a difficult few years for hedge funds. We’ve seen some structural challenges in terms of the industry more generally over the last few years and that’s been reflected in terms of outflows in the industry.

And so in terms of what we think is happening there and then feedback in terms of where we see the opportunities there that have been coming through - coming up.

So if we kind of think about the individual strategies so I will say - I mean, if we go and take the strategies one by one probably the most obvious strategy that dominates I think the hedge fund industry in terms of number of managers is equity long/short.

And equity long/short if we look at over the past 10 years we’ve actually seen a structural - there seems to be a sort of structural challenge for that strategy I would say. It’s been more difficult for managers to generate return and generate Alpha. And so now we are looking at, you know, by all forms many return is not just coming from exposure to the markets.

And so if you look at Alpha over the last 10 years that has been steadily declining across equity long/short. And we think there is a number of reasons for that and some of those we think might change and some of those we think are structurally here to stay.

And so just kind of, you know, kind of going through that very briefly. One I think is the (unintelligible) strategies that we’ve seen in the market. So here we think of some of the - with Premiere we think of people just moving and having exposure just to kind of long indexes.

Now if we think of the index in particular there has been a huge move from a lot of institutional investors in terms of moving a lot within active management across hedge funds and I think (unintelligible) active management and moving that into investing sort of by along the index or ETF instead.

Those indexes tend to be more Large-cap in terms of the ones that FX has done.

In terms of what hedge funds tend to trade actually generally equity long/short funds tend to be long Mid-cap and Small-cap managers where they think (unintelligible) efficiency and tend to be short Large-cap managers.

And so those structural flows have actually been very challenging for hedge funds. Have made it more difficult generally. But that also means if we saw a shift then potentially you could see people (unintelligible) on that by the end of the cycle but that’s not something that some of that we would expect maybe it could potentially reverse. But there is generally going to be a headwind in terms of the flow there.

The second thing I think I will highlight since I’m the quant Strategist this is something we hear a lot about in terms of they are now bigger in the market than they used to be.

And here there is a whole range of different quant strategies that can vary from what a lot of people think of as long term trend followers that tend to try and exploit momentum of trends in the market to sort of - to kind of statistically arbitrage. And people are taking very - using kind of complicated algorithms to try and kind of predict what’s going to happen in terms of market moves.

And so that that also had a big impact and probably, you know, without me maybe going into the detail of each of those strategies what that has meant in terms of equity long/short is that. When it was 5 or 10 years ago a lot of managers were focused on 6 to 9 months type moves for looking in terms of analyst forecasting changes, company numbers on quarterly basis.

That shifted to a much longer time horizon where they find are less challenged by the state market strategies. So there we’ve seen it’s now quite common for equity managers to focus on 2 to 3 years out and actually if you are kind of 2 to 3 years out you are an interim because you can naturally see a bit more beach in terms of your returns to the interim.

The other is in terms of platform funds. So this has also been a big structural change in market if we think of people at the points (unintelligible) Millenniums of this world. These are big managers who are generally they have potentially a lot of small traders.

Those traders don’t necessarily need to be of the same quality. Some looking to make maybe smaller kind of return targets than an individual manager would need to make. But they would take those small returns actually level them up.

And so they will combine that with, you know, risk management, (unintelligible) to try and make that work as another strategy itself. That would then - because they can play shorter term because they are only looking for smaller returns they then can get involved in things that then maybe, you know, small individual managers couldn’t. That’s meant generally for equity long/short.

So these things have been the biggest things that have happened.

David Lebovitz: Yes. And I want to gravitate toward something you said about quant strategies and specifically for arbitrage strategies and the potential for these more momentum and quantitatively driven funds to actually exacerbate volatility on a very short term basis.

I mean, I think back a couple of years ago, you know, when we started in industry if you saw the stock market move 1 to 2% in a day, like, that was a really big deal.

Now, you know, you see 2, 3 4% moves in the equity market and everybody kind of says, “Oh. It’s the quants.” And, you know, just blame it on the math guys.

While short term volatility has certainly increased and I think, you know, the past 18 months have been a good representation of that dynamic. Structurally speaking I think it’s difficult to deny that things like quantitative easing and zero interest rate policy have structurally depressed volatility over the current cycle when you look across longer periods of time.

But, you know, as we sit in our seats and think about the outlook this year and into the following year, you know, we do think that the uncertainty around what the Fed is going to do - are they going to sit tight? Are they going to cut?

Probably not going to hike but, you know, there is still - it’s uncertain and we are going to be passing the Fed statements for more information going forward.

That coupled with uncertainty surrounding trade and really the broader trajectory of economic growth and the potential for weakness in manufacturing to impact the services side of the equation. We think that could begin to put a bit of upward pressure on volatility.

And actually a chart that we show in our Guide-To alternatives look at the relationship between the federal funds rate and the VIX. The Fed funds rate tends to lead the VIX by about two years so the rate cuts - I’m sorry. The rate hikes that we were receiving in 2017 and 2018 are finally beginning to work their way into the equity market and we think that’s going to continue to push vol higher.

As we’ve kind of touched on high vol should in aggregate be good for hedge funds.

Lynnette Ferguson: Yes. I think that the high vol in aggregate should be good because you would expect - I mean, you need movements in terms of prices for people who are trading longer/short positions to be able to make money.

I think it’s worth highlighting and we saw this in the end of Q4 - in Q4 last year spikes in volatility can be very difficult for hedge fund managers. And so for a lot of strategies if we have a severe spike and the actual spike itself is difficult sort of a kind of more elevated level of volatility we think should be good.

And would be we would expect equity long/short, would expect, you know, in terms of product managers, quant managers, you know, value managers and the kind of quant managers we think would all benefit from an increase in volatility I think that’s true.

What is also important though in terms of your comment from a dispersion perspective and I think that what’s been interesting is that even with the recent setbacks we had where I think we had (unintelligible) quite a bit of volatility in May under the question about whether with what was happening with the trade rules, with the tweaks that are coming out from Trump on whether really despite the Fed’s efforts earlier in the year sort of to calm market whether we are going to see a return to much more volatility.

There is actually signs that there are - there signs in the market they may be not as willing to tolerate bad news as they were before. And so that sort of - there some concern I think from investors. We hear this like from hedge fund managers and lots of investors who were looking at hedge funds they are very concerned about where we are in the cycle.

So are we late cycle? You know, we were looking - you know, we were going to have a recession at one point? People are thinking it might be later this year or maybe the next couple of years. But that’s something inevitably everybody is beginning to think about.

And so what you’ve seen in a lot of companies is what you haven’t seen in the last few years when everything kind of moves together. You talk about correlation being very high, dispersion being very low is what we’ve seen this year is there has been much more intersect dispersion.

So we are all just (unintelligible) leading everything if you are in the (unintelligible) just went up.  If you had - if you missed your earning, if bad news came out about your stock where that wasn’t necessarily punished before that does seem to being punished now.

I’m sure if this - it’s a good sign I think for hedge fund managers because that sort of dispersion and the market being a bit more proactive in terms of what it’s doing tends to work very well. But also this question comes up about what that actually mean - it sort of feels a bit more like we are getting to sort of a more late cycle in terms of the environment.

David Lebovitz: Yes. And I think we undoubtedly moving towards the latter stages of this cycle. And one of the things that we have picked up on again in our Guide-To alternatives is that as you see volatility move higher, as you see dispersion widen out, as you see correlation fall. The Alpha that hedge fund managers are able to generate tends to improve.

So even if the nominal level of return is a bit disappointing like the manager selection, the manager skill, their ability to pick the winner and avoid the losers does come through even in periods where volatility is representative of the uncomfortable investment environment broadly.

Lynnette Ferguson: Excuse me sir. Also one thing I was going to say is that, with volatility I think one thing we should bear in mind, even if we are seeing volatility maybe lower than we would expect at the beginning of this year. I think it’s fair to say at the beginning of this year lots of people were looking and saying we thought this is the best environment for hedge funds that we’ve seen for a number of years because we expected more volatility and dispersion in the market.

Even if it comes down we are actually not expecting it to go back to say what it was in 2016, 2017 when volatility was at hundred years low in 2017.

That sort of level of volatility which we find is challenging if (unintelligible) quant managers who would expect to perform, you know, the type of managers that we tend to prefer tend to be managers who will perform regardless of what’s happening to market. But they still need a base of volatility to occur but that level of volatility doesn’t need to be that high.

And so we don’t think we are going to go back to that and so even if it’s not the absolute sweet spot of where hedge funds would prefer from a volatility perspective we don’t think it’s going to be as bad as it’s been in the last few years.

David Lebovitz: And so I think, you know, we’ve unpacked a lot today around an asset class that has certainly struggled in recent history but it does feel like the tide may in fact be beginning to turn.

So I just want to pose one last question to you before we wrap up here today. You know, what are clients asking about? What are clients looking for? What have your client conversations been like over the past couple of months? And what do you think may be some evolving trends in the hedge fund space that, you know, our listeners can be cognoscente of going forward?

Lynnette Ferguson: So I think it’s fair to say that at this time most of our client conversations are down to two themes and the themes themselves are actually quite different.

And so the first of those themes to tie back to what we just been talking about is this, where are we on the cycle and people looking for correlated returns.

And that played out in terms of people looking for more idiosyncratic strategies themes that you don’t want them to correlate with that broader portfolio. And that might bad (unintelligible) needs a hedge fund, maybe they have been low on the hedge fund allocation recently or they have got an existing portfolio and they are trying to fix something in there.

And so those sorts of looking idiosyncratic returns tend to tie into more (unintelligible) strategies. So let’s think about things like say reinsurance has come up in terms of some of the quantitative strategies some of those strategies tend to work very well.

Machine Learning there has been something that, there is the new additive quant that looks particularly (unintelligible) by the crowding that we are maybe seeing across the quant market and they are particularly attractive and interesting actually as in the side to Machine Learning.

Machine Learning managers generally we saw disrupting the market and particularly with quant managers in Q4 last year and what we saw in May this year actually don’t seem to being affected by that. So we were quite interested to see they really do seem to be doing something different.

So Machine Learning but also in terms of the private side (unintelligible) again talked about hedge funds here but it’s also feeding into what people are looking at in terms of the credit side from the private credit perspective.

It’s the same thing of looking for uncorrelated returns and so where people have got an ability to take a little bit more liquidity in that portfolio. They are also doing that as a way of trying to get access to some form of return in this late stage of the market.

The other theme that we are seeing and it’s a big theme that actually we are seeing globally is EST. And so for people who might be less familiar though I think it’s probably fairly well-known kind of globally across the market (unintelligible).

But for those people who are less familiar the BSG was sort of talking about the environmental, social and government factors in terms of managing money. And this is something that’s really coming for investors and less so I will say for managers and has been - the hedge fund industry has probably been the slowest area would say in the financial industry to fail to pick up on this.

But what we are all seeing is now we’ve actually been at the forefront in terms of talking to our managers and really kind of getting them involved in this.

Now how it’s happening it’s been different in terms of global compensation. So we find that in Europe, in Asia and in particular New Zealand and Australia they are very concerned about sort of the more (EMEF) size.

So in impact investing how can they look at things that impact the environment? That as you can imagine is a more nuance question in the U.S.

And so it will be that in the U.S kind of the West Coast investors are very keen on ESG particularly those (EMEF) whereas say in the East Coast of, you know - actually not East Coast but in non-west coast and also particularly in public pension funds this impacts diversity which is very important to them. So these are the same factors that they absolutely tend to be focused on.

I mean, investors are really at the moment trying to marry their wish and desire to do this with their fiduciary duty to actually generate good returns. And so we see in places like Canada and in the U.S that there is a focus, returns come first. And so they are really trying to find a way that they can actually do return both the ESG whereas some other investors they have to just need to do it.

David Lebovitz: Yes. I mean, the ESG trend is undeniable. And I saw a chart yesterday and the number of times the ESG is mentioned in Russell 3000 Company Earnings Call and that chart goes up into the right. We like charts that go up into the right.

Anyway, Lynnette thank you so much for joining us today on the Center for Investment Excellence. We hope to have you back again sometime soon.

Lynnette Ferguson: I would love to. Thank you.

David Lebovitz: Thanks.

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 David Lebovitz Global Market Strategist and with me today is Lynnette Ferguson of JPMAM hedge funds and alternative credit solutions team.

Thank you for joining us today on JP Morgan Center for 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 on in iTunes and on our Web site recorded on June 7, 2019.