HEDGE FUND - 20/1/24 - Man Group - Q1 Strategy Outlook

SUMMARY

The fourth quarter of 2023 was unusual for traditional assets, with equity markets finishing strong despite lingering economic concerns, increasing corporate defaults, and a squeezed consumer. Central banks, particularly the Federal Reserve, adopted an incrementally dovish rhetoric, which buoyed risk assets and drove down bond yields, expecting multiple rate cuts in the upcoming year. This, in turn, led to low levels of implied volatility, making it challenging for hedge funds to generate alpha. However, the authors believe that the global economy continues to undergo a transition period, and the low levels of implied volatility may not last through 2024.

OUTLOOK AND STRATEGIES

The authors maintain a broadly positive outlook for hedge fund alpha, favoring Credit Long-Short, Convertible Arbitrage, Micro Quantitative, and Global Macro strategies. The optimism in relative value credit strategies stems from the uncertainty and internal dispersion in credit markets due to higher rates and refinancing needs. Capital structure arbitrage opportunities are expected to be more attractive if equity market volatility increases in 2024.

Convertible Bond primary markets are likely to remain active as issuers move into the asset class to address forthcoming debt maturities in the face of higher rates. The stance in Micro Quant and Global Macro strategies is based on expectations of a more volatile landscape next year, where both top-down and bottom-up approaches may be successful in capitalizing on dislocations and dispersion.

On the other hand, the authors have downgraded their outlook for Merger Arbitrage following a good run in Q2 and Q3 of 2023. They now see less of an anomaly in the price of mergers and, therefore, have reduced their conviction. The outlook for Long-Biased Equity Long-Short remains negative due to the overvaluation of equity markets relative to history and the downside risks present in the current economic climate.

CREDIT STRATEGIES

In the credit space, the authors continue to hold a positive view on Credit Long-Short and a neutral view on Distressed. The prolonged period of relatively benign market conditions indicates that there is still more to do in relative value trades in Credit as opposed to restructuring opportunities. US High Yield spreads closed the year near their tightest levels since pre-2020, below historical median levels, which feels at odds with the growing level of defaults and poor recovery rates seen in the asset class over the last year. The authors suggest that this may be due to the increased appetite of investors to allocate to higher quality credits given the optical appeal of yields close to estimates of fair value. There is still a large universe of convertible bonds trading below 80% of par value, and of these, more than 40% have no other debt, making Convertible Bonds a lucrative source of alpha for idiosyncratic opportunities. Unlike traditional credit markets, spreads in high yield convertible bonds remain wide, providing an additional yield pick-up for managers with good stock selection skills.

Primary market activity in CBs is expected to remain active as issuers seek to proactively address an expected high level of bond maturities arriving in 2025 and 2026. Additionally, the expansion of convertible bond markets and increase in issuer diversity are positive tailwinds for the strategy in the long run.

QUANT STRATEGIES

The authors retain a favorable view of Convertible Arbitrage, despite broad markets trading close to estimates of fair value. The increased appetite for higher quality credits has created a reasonably large universe of convertible bonds trading below 80% of par value. These conditions provide a lucrative opportunity for idiosyncratic strategies, especially for managers with good stock selection skills.

In Structured Credit, the authors have maintained a neutral stance due to the variation in the attractiveness of opportunities across the space. Loss-adjusted yields remain historically attractive in many sectors due to the higher risk-free rate, although they have rallied somewhat from the wider levels seen in early 2023. The fundamentals in the consumer and residential/housing markets remain generally solid, but concerns remain focused on a significant and broad-based increase in delinquencies and defaults in residential and consumer asset-backed securities (ABS) due to an economic downturn. In Macro Quantitative strategies, the authors maintain their neutral stance. They prefer alternative trend strategies to simple trend following given the volume of assets allocated to trend risk premia over recent years and the ability of alternative trend strategies to generate alpha from capacity-constrained markets. Performance in non-trend systematic macro strategies has been generally weak in 2023, with traditional lead/lag effects failing to gain traction in the somewhat unusual post-Covid, higher inflation, higher rates, but resilient economy regime.

MICRO QUANT STRATEGIES

The authors remain positive in their outlook for Micro Quantitative strategies. They expect equity market dispersion and volatility to increase in 2024, which should generally provide a better backdrop for Micro Quantitative strategies. For some time, they have transitioned away from the more fundamental Equity Market Neutral approaches, as these have become increasingly commoditised through Alternative Risk Premia strategies.

Over the last year or so, the authors have seen a broader pool of high-quality managers in this strategy as managers spin out from platforms or reach a level of development where they can be genuinely competitive with the best practitioners in the strategy. However, they still have concerns over the saturation of highly levered strategies at the largest hedge fund platforms and the risks that platform destabilization may pose on the wider industry.

MACRO STRATEGIES

The authors maintain their positive outlook for Global Macro strategies, anticipating greater risk-taking in end-of-cycle trades. They are entering an unusual period for global economic policy, with predictions of multiple rate cuts in the short term despite none of the usual reasons for looser monetary policy. The opportunity set for Macro managers lies less in predicting these events than the market volatility and reallocation of capital that can occur after them.

Geopolitics and fiscal dynamics should present plenty of sources of catalysts for large changes in market behavior across the globe throughout the year. Additionally, 2024 is the year of elections, which will likely contribute to the unusual period of global economic policy.

EVENT DRIVE STRATEGIES

The authors have reduced their outlook on Merger Arbitrage to neutral following a broadly correct call to increase for the past two quarters. Annualized spreads have tightened over the last quarter as less regulatory risk is now priced in to deals. Several high-profile deals closed in the second half of 2023, and managers have been rotating their books into new opportunities.

Deal volumes remain close to average, in line with post-Covid levels but below the higher volumes seen in the 2015-2019 market rally. Managers are generally bullish about the potential for more deals in 2024 due to the greater certainty in the financing environment following the peak in interest rates and the resolution of banking sector issues seen in H1 2023. The downside risks to the strategy right now focus on a deterioration in the broader economic picture, such as weaker equity markets and higher levels of volatility.

EQUITY LONG/SHORT STRATEGIES

The authors continue to hold a preference for low-net Equity Long-Short managers and have maintained their neutral rating for Market Neutral Equity Long-Short and a negative rating on Long-Biased Equity Long-Short. Patience is likely to be important in extracting value from equity markets in 2024, which looks to be a year of transition with divergent economic outlooks across countries and regions. Alpha generation from stock picking is likely to be supported by higher equity volatility caused by the feed-through effects of higher rates (i.e., corporate defaults, a squeezed consumer) and by uncertainty around geopolitics and the crowded election calendar over the next 12 months. While not trying to forecast factor performance, the authors maintain a slight preference for quality and profitability metrics, which should help guide stock selection as companies with strong cash flow generation and stable balance sheets are generally best positioned to navigate a slower growth regime.

CONCERNS AND RISKS

One area of growing but rather nebulous concern is the impact on alpha generation of any potential failure of the larger hedge fund multi-strategy platforms. There has been a significant and aggressive war for talent across these platforms in recent years, sparked by higher-than-average alpha generation for the hedge fund industry in 2021 and 2022. The largest players have become larger, imposing more onerous liquidity and fee terms for investors to protect their business and to allow for greater largesse when attracting new employees.

The risks of failure of these platforms are now being looked at by global regulators, given their large market footprint. The authors suggest that it seems sensible to monitor ones exposure to crowded positioning and common factors and to hold exposure to managers who are generally smaller and investing in more liquid securities, as this provides much-needed nimbleness to navigate any future contagion events.

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