Hedge Funds Outlook
Opportunities in sustainability, next-generation digital and value
Among the convictions shared by our hedge fund professionals investing across a diversity of strategies: Technological advances will continue to reshape the investment landscape in 2020, offering stock selection opportunities—some arising from ongoing tech disruption and others from investors’ utilization of sophisticated techniques such as machine learning. They also see excellent opportunities in sustainability themes, both long and short, as companies evolve their businesses and investors grow more supportive.
Next-generation digital transformation
As tech spending continues across industries, our managers anticipate opportunities as digital transformation initiatives go mainstream, such as the broadening adoption of artificial intelligence, the build-out of public 5G networks and the growth of cloud computing. That should fuel capex1 and rising demand for software and services. Already, 5G telecom has been rolled out in Korea and China, and further expansion should create a tailwind for manufacturers, supply chains and telecoms, spurring M&A. This macro backdrop informs hedge fund strategies as our managers anticipate a new generation of industrial applications and opportunities such as connected cars, the internet of things (IoT) and smart cities.2
They expect one advancement in particular—the increased application of machine learning—to continue making a material, positive impact on many industries, including finance and hedge funds. Statistical arbitrage managers apply machine learning techniques to the ever-increasing amounts of available data, producing unique alpha signals that drive returns. Those operating on shorter time horizons can often benefit from equity market volatility; the 2020 U.S. presidential election and other uncertainties may increase the attractiveness of such a strategy.
The ascent of sustainability
We believe that the hedge fund industry is at an inflection point: 2020 should be an important year for managers to increase the integration of environmental, social and governance (ESG) criteria and sustainability across their businesses and investment activities.3 Whereas ESG was previously seen as an approach to risk measurement, it has begun to be a broader consideration (EXHIBIT 1). Sustainability is becoming a driver of growth and a disrupter creating investible, structural themes in the marketplace—from millennial habits to metals recycling—as consumers and governments put pressure on businesses to deliver more sustainable products and services. The fundamental changes involved in this transition to a lower carbon economy should influence medium-term money flows. Our managers call the risk-adjusted returns from this type of investing “sustainable alpha.” Sustainability-led disruption was first seen in power generation (in the shift from carbon-intensive fuels to wind and solar); the next sectors to experience it should include transport, agriculture, automotive, buildings and industrials.
The sustainability gap
EXHIBIT 1: % OF INVESTORS VS. MANAGERS WHO THINK ESG WILL BECOME MORE IMPORTANT IN THE NEXT 5 YEARS
While some sectors and businesses are leading this evolution, others are falling behind (none look more troubled than the commodities sector). Investing in sustainability will be crowded, making manager selection crucial. Active investors will be able to take full advantage of the theme across industries, through long and short exposures in different asset classes.
Factor investors expect the rebound of value
Our quantitative beta strategists say value, which has become extremely inexpensive, is one of their best bets. They expect a rebound to reverse a factor trend prevalent since early 2017. They see a bubble building among lower quality, higher growth names, so the opportunity is likely to come from shorting those rather than just being long the value factor. It is hard to say just when a catalyst could effect this rebound, however. One potential catalyst is a hiccup in the credit markets—highly levered companies in need of refinancing, for example, experiencing a hit to their bottom line.
In addition to finding many value stocks attractive, several other trends and areas across equities continue to present interesting opportunities. For instance, in biotechnology, advances in gene therapy and ongoing consolidation in the space continue to offer very good opportunities for those with the technical expertise to compete. Geographically, our hedge fund investors consider Asia an attractive region—particularly Japan, as positive trends in corporate governance continue to unlock value. Finally, a few overlooked areas present interesting, albeit selective, opportunities, such as special-purpose acquisition companies (SPACs) and closed-end fund arbitrage, including activism.
Riskwise, our hedge fund investors note that full valuations, an increased probability that a less business-friendly candidate could win the U.S. presidential election, strategy crowding and factor volatility all constitute downside risks.
1 USD 1 trillion in capex, globally, is expected in the coming 10 to 15 years, accelerating in 2020 and 2021.
2 Cities that incorporate information and communication technologies to reduce resource consumption and wastage and lower costs in energy, transportation, utilities, etc.
3 Following a landmark 2019, when “climate emergency” was the Oxford Dictionaries Word of the Year.