Alternative Asset Management Outlook
On the back of COVID-19 vaccinations, economic recovery whilst uneven, accelerated in many parts of the world in 2H2021. In some markets, inflation and not COVID-19 is now feared as the drag on future growth and equities. The yield curve, particularly in the US, steepened through Sep 2021, which resulted in a broad decline for equities that spread across most regions and sectors – the month ended on a rough note for the MSCI World and S&P500, and was one of the worst September showings since the 2008 Financial Crisis.
Given the uncertain near-term outlook as markets begin to adjust to a slowing of central bank asset purchases, full valuations and rising interest rates, we believe it is prudent to focus on strategies that do well in volatility and are ready to take advantage of market dislocations.
4Q 2021 STRATEGY HEATMAP
While realized volatility was below average during the quarter and especially at the end, we believe that this trend will likely reverse. Foremost, we believe that the inflation debate and supply chain issues will result in higher volatility which will prove supportive of relative value strategies. Among such strategies, we favor capital market trades given the strong pipeline of opportunities across secondaries, IPOs and other issuance. Managers with strong sourcing relationships – both directly and through Investment Bank partners, should continue to flourish. While there is less broad-based dislocation as compared with 2020, there are a number of smaller inefficiencies across relative value strategies. As such, we continue to build exposure to smaller multi-strategy platforms that can nimbly rotate capital and flex their balance sheet efficiently to capitalize on such opportunities. Likewise, quantitative / statistical arbitrage strategies should see a solid opportunity set as realized volatility moves to normalized levels, albeit with ongoing headwinds related to factor rotations. Underweight strategies such as options and convertible bond arbitrage due to stretched valuations.
Macro / Opportunistic
The environment continues to be conducive for macro strategies on the back of record central bank activity aimed largely at guiding economies out of COVID. Policy divergences across countries – with policy remaining loose in some while tightening in others, should create trading opportunities. We expect inflation-focused trades in fixed income and commodities to remain significant in portfolios whilst the positioning on equities is mixed. Cryptocurrencies and their derivatives may become more pronounced after contributing to profits this year. Underweight strategies such as plain vanilla CTAs and Emerging markets where spreads appear too narrow to justify the tail risks today.
We expect dispersion to remain high, albeit with ongoing factor rotation, and a range bound to slightly higher equity market. Low to mid net Long/Short generalists in the US should prove relatively resilient to volatility/inflation concerns, but we generally see better opportunities elsewhere. Opportunities in Europe are relatively attractive given moderate valuation levels and the tailwind of a broader recovery from COVID. We are also optimistic about strategic equities such as activism/corporate governance opportunities where a strong process to unlock value and to create catalysts for price action has been demonstrated. Underweight strategies that are long biased given stretched valuations and higher expected levels of price and factor volatility.
Merger Arbitrage / Event Driven
The dislocation in the SPAC space has created attractive opportunities especially in late-stage SPACs that are trading below trust value and in warrant trading, where both have limited downside risk. New issue volumes have moderated but more importantly, are being offered at far more attractive terms than before which substantially improves the upside. Underweight strategies such as Merger Arbitrage as spreads continue to remain tight and investors may not be compensated adequately for the risks, including regulatory risk.
Private credit generally fared well over COVID, owing perhaps to the more conservative nature of creditors. Deal volumes and yields in US direct lending for example, have been strong over most of 2021 while 2020 defaults remained relatively low. That said, COVID has created winners and losers, e.g., housing vs. lodging and retail, resulting in healthy pipelines today in performing credit to the winners and restructuring opportunities in the hardest hit sectors. We see selective opportunities in smaller, nimble mangers especially those that have the ability to structure financing solutions. Underweight strategies such as ‘plain vanilla’ corporate and structured credit strategies due to very tight credit spreads.
Should investors be adding to Macro strategies today given the narrative that is driving the markets?
Macro strategies add diversification as they tend to be less correlated to traditional markets and other hedge fund strategies. Historically, they have done well in troubled markets due to their lack of structural biases, their liquid characteristics which allow active repositioning, and their ability to benefit from a flight to quality. In today’s environment where top-down forces like Central Bank action are dominating the markets and there is divergence at the country level, it could make sense to maintain a small overweight to Macro. The opportunity set for this strategy has been very strong over 2020 and many managers have done very well. In general though, Macro is a strategy that is hard to time, and we tend to maintain an allocation regardless of the market environment.
Since late 2020, Inflation and Economic Re-opening have been lucrative themes, and have been expressed typically as long positions in commodities and energy, and short positions at least in US fixed income on the expectation that the Fed will have to roll back accommodative monetary policy sooner rather than later. These ideas have played out to an extent despite some pull back during the summer months especially in the US, which hurt a number of macro funds.
There is no consensus among macro managers on inflation. Some think inflation will overshoot before it needs to be brought down aggressively while others think the price increase will be controlled and relatively gentle. At any rate (no pun intended), interest rate volatility has moved higher and should remain at healthier levels, which on balance is positive for macro managers. From what we see, macro managers have generally adopted a more tactical approach in the short-term while waiting for a clearer picture to emerge on the inflation front.
We typically favor macro platforms for a number of reasons including the fact that the multi-portfolio manager framework eases the pressure on individual traders to take risk when they do not find compelling opportunities; also, the combination of various trading styles can create a more attractive risk reward.
What is your view on China? Has this changed due to recent events?
China is a compelling source of alpha given its large, inefficient markets. As the markets open up, global investors are getting better access to China A shares and hedging instruments such as commodity futures, commodity options and stock index options. The opportunity set is rich, and includes different strategies and asset classes such as systematic long only, market neutral A shares, commodities, convertibles, event driven trades etc.
In equities, we believe that a long short approach will provide the best risk adjusted returns over time. Growth is slowing, competition in some sectors is increasing and the structure of the economy is changing – this creates winners and losers.
We prefer to focus on sectors with accelerated growth dynamics such as healthcare, renewables and high-technology—where this growth is driven by key stakeholders- policy makers and consumers.
Chinese healthcare is an example of where there is growth and significant disruption - per capita expenditure has grown at 10+% over the past decade but is still very low compared to developed markets. At the same time, regulatory changes have led to an accelerated timeline for new innovative products and have also increased investment, while more commoditized products are being forced to lower prices dramatically.
Some of the recent regulatory action against the Internet companies was arguably long overdue when compared against anti-monopoly and data security practices in other countries. The regulatory process is not a transparent one; it is also a complex one and we know there are multiple objectives behind these series of moves, from addressing wealth inequality and demographics to strategic human and capital resource allocation.
All of these make it difficult to forecast, which creates uncertainty and risks for investors. We believe this is an inflection point and investors should expect greater government oversight in areas where technology, consumer/labor interests, and national competitiveness intersect. Policy matters, and its impact on the operating environment is an important part of our managers’ investment analyses. That said, private enterprises have generated enormous wealth and employment, and we think China is committed to utilizing markets to continue its progress.
The pain in the China sell off was quite muted for many global hedge fund managers as their net exposure to China was at historical lows at the sell off. Many were out of the online education names and sparingly in the Internet names by then.
The sentiment today is still cautious. Some hedge funds have added back to Internet names where they believe these have strong business models and are either not direct targets of new policy or where they think most of the policy is already largely behind them. Yet others have chosen to focus on sectors where policy is likely to be a tailwind, e.g., semi conductors, components etc.
The impact of the recent stress in the Chinese property market has so far been contained to the equity and credit of the developers and some closely-related companies. Our managers have had minimal direct exposure to the sector, having long viewed the property development business model in China as overly reliant on leverage. They continue to monitor the situation with an eye toward identifying potential opportunities and to assessing the impact on the broader economy.
What role do SPACs play in a portfolio?
Despite a volatile year for SPACs, our exposure has contributed positively this year. SPACS for us are a credit substitute – we are seeking a low volatility, defensive return. Unlike much of the liquid credit space, SPACs have a clear and legal basis for a value floor (because the structure gives investors the right to redeem the cash that is held in trust and invested at money market rates while the SPAC is seeking a merger target). There is also upside from the warrants that are at no cost when you purchase SPAC units.
With interest rates across the globe at historically low levels, the defensive return of a SPAC portfolio backed by trust value offers a complement to a multi asset portfolio. Our exposure is very diversified across a large portfolio of SPACs.
SPACs seem to have fallen out of favor – is there still opportunity here and how are managers trading this space?
We believe there is still opportunity in SPACs. Discounts to trust value remain wide, which creates an attractive entry point as this can be likened to buying cash at a discount. In the US, there are almost 500 SPACs that currently exist and/or are launching so there are plenty of investment options. As with any stock, investors need to clearly understand the risks of owning a SPAC at different parts of its life cycle.
Could the SPAC boom take off in Asia as Singapore becomes the first financial hub in the region to host SPAC listings?
SPACs are now recognized as an alternative Initial Public Offering (IPO) structure on the mainboard of the Singapore Exchange, which could meaningfully boost local equity markets. That said, the recent dynamics of the US SPAC market has been well covered in the press and thus we expect investors to be looking closely at the credential of sponsors and their ability to source good companies with near term profitability.