As 2016 gets under way, investors need to guard against short-term volatility spikes and contagion risks from factors including geopolitical turmoil and pressure on oil prices. How is the environment impacting the risk/return characteristics of various hedge fund strategies?
Volatility and dispersion are creating long/short potential. Global markets are more volatile and dispersion is higher. The US is removing accommodative monetary policy and economic conditions are becoming more difficult in many regions. As these trends play out, we believe that the market will increasingly differentiate between companies, industries and asset classes. This should improve the opportunity set for equity hedge strategies.
We tend to favor strategies that use bottom-up, fundamental analysis to exploit long/short security-specific opportunities. Fundamentals don’t always drive short-term moves in security prices—sentiment and asset flows can certainly impact markets. But we believe that fundamentals matter over the long term.
Of course, no investment strategy is riskless. If markets were to sell off dramatically, fundamental long/short equity strategies would likely hold up reasonably well relative to broad-market indices, but the opportunity for absolute returns would be limited. While these strategies generally use shorts and market hedges to protect downside, they tend to be net long and subject to some market risk.
Fundamentals are feeding strong deal activity. Macroeconomic fundamentals—low oil prices, low funding costs and robust corporate balance sheets—continue to fuel the strong deal activity that tends to benefit event-driven strategies. And with revenue growth otherwise challenged in a low-growth economic environment, corporate deals continue to offer potentially compelling solutions for companies. As a result, corporate activity remains at near-record highs across a variety of areas, including spinoffs and merger activity.
Many event-related activities lead to changes in corporate structure, balance-sheet composition, incentives and management quality. All of these can set up long and short opportunities for investors who can evaluate the potential impact of these changes.
2015 challenged event-driven strategies, but spreads are wider now. A number of high-profile mergers were delayed or derailed last year, and several widely-owned, catalyst-driven names declined. Greater regulatory risk was a big factor: negative reaction to tax-driven inversion transactions, a more muscular Federal Communications Commission and a more aggressively anti-trust Department of Justice all played a role. As these factors impacted returns, deal spreads adjusted as well. At this point in the cycle, spreads have widened to a point where, historically, it’s been a good time to invest.
Broadly speaking, we’re still very positive on the event-driven space, particularly on merger arbitrage and strategies that can take advantage of the most attractive investment opportunities across equity and credit markets. However, corporate transactions rely on credit markets to finance deals and a severe decrease in available credit could challenge these strategies.
Debt burdens and lower liquidity bear watching. With dealer inventories at record lows because of regulatory pressures, we continue to see less liquidity in credit markets overall. However, increased volatility could benefit relative-value credit strategies.
Recent struggles for distressed credit—but a possible silver lining. The lack of liquidity in credit markets, together with the selloff in the commodities complex, have caused long-only high yield and distressed credit strategies to struggle over the past 18 months as spreads widened dramatically. We don’t know exactly how this cycle will play out, but historically, these strategies have enjoyed strong recoveries after painful drawdowns and increases in the volume of stressed and distressed bonds.
As we’ve seen over the years, the environment can change quickly, and nimble strategies could find a very rich opportunity set ahead. However, while spreads have widened dramatically, if we move into a recession, the current depressed prices could be validated.
More risk and dislocations bode well for macro strategies. For years after the global financial crisis, macro strategies struggled with a lack of volatility and tightly correlated global markets, as central banks around the globe followed the same game plan. Recently, however, market volatility has increased as central bank policies have diverged. US Federal Reserve monetary tightening has boosted the dollar, adding to the pressure on commodity prices and emerging-market asset values.
This environment should improve the opportunity set for global macro strategies that make-relative value trades on currencies, interest rates, commodity prices and equity markets globally. While we’re more bullish on macro strategies than we’ve been in recent years, we remain cautious about strategies that make concentrated bets and use high levels of leverage.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.