This time, it really is different. Nobody had ever imagined the possibility of the world economy being put to sleep for weeks. In an effort to fight the COVID-19 pandemic, governments across the world have implemented social distancing and lockdown measures. Rest assured: we will not be discussing these strategies or the efficiency of the plans, as there are more than enough experts for that.
In the face of uncertainty, markets sold off very aggressively. In the heat of the sell-off, there was nowhere to hide, since depressed asset prices were being pushed lower by panicked investors selling what they could, not what they wanted, in a race for cash. Markets have experienced unprecedented rapid moves as well as market volatility levels not seen for the last 30 years. Central banks and governments have stepped in quick and hard to stabilize investors, to protect the real economy, support the unemployed, but also – in certain credit markets – to reboot liquidity, which had vanished due to the lack of financial intermediaries. Times are hard but this is not the end of the world. Stay safe and healthy.
The HFRX Global Hedge Fund EUR fell -6.46% over the month.
Long short equity
Overall, LS Equity funds held up relatively well during the month. On an absolute basis, the average performance was in the negative mid-to-high single digits. However, on a relative basis, the strategy offered decent capital protection against the market sell-off. Until mid-month, LS Equity funds were very resilient, with the short book more than adequately offsetting the losses generated by the long investments. The managers were keeping their net exposure stable and letting the gross exposure decrease by market effect to adjust for the higher volatility environment. During the week of 16 March, there was an important sell-off of crowded longs. At the same time, the short book was not so profitable. Short positions did not follow the market, due, in part, to short-ban regulations and short-covering to take profits. LS strategies investing in technology or digital businesses have tended to outperform, since they are long businesses benefiting from social distancing measures, and thus made money from shorting old economy themes like main street retail, which are among the most affected.
It will take some time for corporate management and investors to gain more visibility on the real impact that social distancing measures have on revenues and will be dependent on many variables (i.e. government social distancing rules going forward, finding a treatment, the success of stimulus measures, additional epidemic waves). Finding a solution to the current crisis is therefore not a binary call that can be solved overnight. Long Short Equity strategies are, in our opinion, an interesting strategy to consider for navigating the current market environment, since they can modulate their risk appetite and generate returns from their long and short positions in a very wide range of investment themes. Good stock-pickers will be able to select winners and losers.
Global Macro
The average performances of Global Macro strategies during the month were flat-to-down-low single digits. However, performance dispersion among managers was relatively high. Considering the high speed of market movements that we experienced in March, the performance that managers printed during the month reflected their positioning pre-crisis and the level of concentration of their investments. Bearish managers usually outperformed with their short bias portfolio since, basically, every type of asset went down the rabbit hole. A fair amount of strategies managed to print decent returns from short trades on energy and EM currencies or from dynamically trading rate curve dislocations. Interestingly, Asia-focused global macro managers used, to their advantage, the information accumulated during the first market stress in January. Considering the high volatility levels and future uncertainty, fund managers are focused on reassessing current positions and reducing risk. The massive stimulus programmes announced by central banks and governments all around the world should help stabilize the market. However, until the current health crisis is contained and we learn to live with it, the outlook will be foggier. In this environment, we would tend to favour discretionary opportunistic fund managers who can draw on their analytical skills and experience to generate profits from a few strong opportunities worldwide.
Quant strategies
Most of the quantitative models had difficulties dealing with the violent and rapid increase in market volatility and asset correlations between the end of February and beginning of March. The extreme and prolonged volatility levels reached during March led to a significant deleveraging of quantitative strategies, generating poor performance and leading to more deleveraging. The implementation of the stock-shorting ban on some European countries helped accentuate the deleveraging effect because managers were not able to implement or adjust the optimal portfolios of long and short securities as defined by their model. Trend-following strategies, benefiting from the strong downward trends on equities, currencies, rates and commodities, were very profitable.
Fixed Income Arbitrage
Fixed income relative value had one of its most spectacular months in history. At the end of February, with US repos starting to show some cracks, the basis (the spread between the cash bonds and the futures) started to widen. While the COVID-19 crisis gained momentum, early March, the cash and futures markets were entirely disconnected. Within 2 weeks, the US basis (whatever the maturity: 2y, 5y, 7y) had reached levels last seen in 2008. As some managers, forced to de-lever, unwound their portfolios, the strategy hit an implied expected IRR of 30%. Once the Fed stepped in, the most experienced managers repositioned themselves and were able to benefit from the tightening. If we are very positive going forward on the strategy, it has nonetheless highlighted the need to be invested in managers with strong set-ups.
Emerging markets
It was a very tough month for Emerging Markets, with the excessive amount of information to be absorbed by the markets leading to massive outflows from the asset class. Considering early 2020 investment outlooks, this asset class suffered probably the most brutal turnaround in the financial spectrum. Instead of weighing EM premium rate risk versus Developed Markets, investors are now considering risks linked to notional and interest rate haircuts of over-levered countries and economies too dependent on oil exports. The market is cyclical and, as such, current massive dislocations are the seeds of future investment opportunities at more interesting entry points. Nonetheless, we remain cautious on the strategy because, on top of fundamental considerations, EM assets might suffer from outflows of capital chasing opportunities in DM High Yield, and from a lack of liquidity.
Risk arbitrage - Event-driven
March was hard for Event-Driven strategies. On average, the funds were down -5% to -10% for the month. For many managers, that corresponds to 3-to-4 years of performance. The result is nonetheless understandable. Merger Arbitrage strategies aim to capture a spread in price between 2 companies putting their businesses together. In an ‘End-of-the-World’ scenario, no one has any idea how to price in that kind of scenario in the heat of the action. Also, moves were exacerbated by the book-size-reducing of some managers. For the last 10 years, the stability of the returns offered by the strategy has attracted a large amount of capital, which tends to reduce the amount of available alpha. The managers we talked to were quick to reassess their portfolio of deals to concentrate their book on strategic deals with strong merging contracts and unload high levered deals or non-strategic deals with Private Equity Fund bidders. Merger Arbitrage offers an interesting embedded deal spread for an average target annualized return of around 10%. This will vary for each strategy, depending on portfolio concentration, leverage and deal risk. It is, however, an interesting entry point for a liquid strategy with clear catalysts in the case of investing in announced deals.
Distressed
Distressed opportunities have finally arrived but not in the way we were thinking of. Instead of reaching the end of the credit cycle progressively, the coma-induced world economy made businesses crash against the wall at a high speed. The question is therefore not about whether there will be distressed opportunities, but how many? Apologies if we seem insensitive at a time of great difficulty for many people around the world. We hope that the monetary and fiscal stimulus plans being put together will be effective and limit the damage to our economies. However, it is a fact that they will not be able to save every business in the world. From the discussions we held with experienced managers, we gathered that credit was being sold off with aggressive quotes for fundamental reasons but also due to a lack of liquidity. Distressed managers are not rushing to dive right in. Assets being sold require deep fundamental analysis to be bid at the right price.
Long short credit & High Yield
Credit spreads for Investment Grade and High Yield markets reached extreme levels unseen since the crisis of 2008. The market was also highly affected by the lack of liquidity, prompting the ECB and the Fed to step up their IG debt-purchasing programmes. The Fed also decided to include High Yield in its buying programmes to smooth the high amount of Investment Grade fallen angels downgraded to High Yield. Rating agencies forecasted that the amount of fallen-angel debt could reach $700 billion in the US, probably too big to be absorbed by the HY market smoothly. Contrary to 4Q 2018, opportunities offered in credit will take longer to be arbitraged, leaving time for investors to review their allocations.