A new, higher volatility regime sets the stage for certain hedge fund strategies
After the lowest equity market volatility in 100 years, our hedge fund investors believe financial markets are undergoing a regime change, entering a new, higher volatility norm. All else being equal, an increase in market volatility helps generate trading opportunities—and several hedge fund strategies stand to benefit as volatility prompts the relationship among stocks, rates and credit spreads to evolve, affecting prices and correlations.
One indicative metric: Realized volatility hit 21% in early 2018 vs. a 7% average in 2017 (EXHIBIT 1). From these early stirrings, the pickup is expected to continue, propelled by the tapering of quantitative easing, the rate hikes expected ahead and generally tighter financial conditions. The potential for inflation, ongoing trade wars, a fully valued market and geopolitical uncertainty around the world also feed the volatile backdrop.
Median equity volatility historically is about 15%, yet in 2017 it fell below 10%; its 2019 range may be 12%–18%
EXHIBIT 1: S&P 500 WEEKLY REALIZED VOLATILITY
Source: J.P. Morgan Markets; data as of November 23, 2018. Forecasts, projections and other forward-looking statements are based upon current beliefs and expectations. They serve as an indication of what may occur. Actual results or performance may differ materially from those reflected or contemplated.
In more volatile markets, certain hedge fund characteristics stand out—including an ability to take long and short positioning, and a focus on uncovering short-term inefficiencies. Those qualities may prove advantageous in the coming year, as fundamentals will likely do more to set valuations and as price dispersion likely grows. Our investors expect complacency to start unraveling and market participants to become more discriminating. Late in the cycle, given the significant growth in corporate indebtedness, when liquidity is withdrawn from the system the weaker among the highly leveraged companies should struggle to roll over their maturing debt.1 As the inability to refinance creates winners and losers in equities and credit, opportunities should emerge, and some of our investors will lean into hedge fund strategies that can survive or prosper under asset class volatility, both sustained and intermittent bouts rolling through.
THE VIEW THROUGH A FACTOR LENS
The outlook is similar for our team that views markets through a factor lens. Value stocks have significantly underperformed since early 2017—the equity value factor is suffering its second-worst drawdown since 1990. However, value stocks have a quality bias vs. more expensive stocks. Further, we have seen the pricing of value vs. expensive growth stocks detach from fundamentals, leaving value stocks more than two standard deviations cheap relative to history. Should borrowing costs rise or earnings expectations for growth stocks fall, we would expect value stocks to rebound— benefiting hedge fund strategies that offer exposure to the equity value factor, particularly those that are market neutral.
Another market-neutral strategy we highlight, merger arbitrage, may experience short-term volatility shocks, yet we also expect opportunities. Given that a high percentage of outstanding merger deals are friendly in nature, and with merger spreads above 10% annualized, our investors see potential in strategies that can capture this premium.
VOLATILE WORLD CREATES TAILWINDS FOR TACTICAL TRADING, IDIOSYNCRATIC EXPOSURES
Volatility shines a spotlight on relative value (RV) strategies, which can reduce market-directional risk in a less benign environment. Cross-asset RV strategies, which trade the relationship between companies’ credit and equity, can continue to benefit from an equity volatility pickup and widening credit spreads. So, too, can market-neutral strategies, which do not time the market, trade the relationship between securities and asset classes.
Short-term statistical arbitrage, with its days-to-weeks investment horizon, should also benefit when elevated volatility creates panicked, sloppy and forced trading across markets. Small market imbalances may offer robust opportunities in stocks whose prices are unduly depressed. The risk to these strategies would be a continued, synchronized expansion with lower levels of volatility (e.g., VIX below 12%).
Statistical arbitrage and other data-based hedge fund strategies also stand out because of developments in data technologies. The sheer volume of existing data has grown dramatically and its nature and sources have deepened while processing power has exploded at lower costs. Sophisticated techniques such as machine learning, neural networks and natural language processing can help ferret out investment signals. The risk is potentially one of crowding.
Concentrated, not diversified, factor exposure has rewarded investors since 2017. But under bear market conditions, we believe opportunities should arise across a range of factors and hedge fund approaches, underlining the importance of a diversified range of systematic market-neutral strategies.
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