Considerations for Alternative Asset Investors
Hedge Funds | COVID-19 April 14, 2020
Uncertainty surrounding the magnitude of the COVID-19 outbreak coupled with a strong selloff in crude oil prices and energy-related companies have pushed global stocks into bear market territory. It, followed by a historic spike in the unemployment rate, raises the likelihood of a global recession. This has resulted in substantive volatility in financial markets and it is no surprise that the alternative investment fund industry has been impacted as well.
Investors look beyond traditional asset classes in order to preserve capital and generate uncorrelated positive real returns. Those with exposure to alternative assets, including hedge funds and private markets, can improve the resiliency of their portfolios through diversification as well as potentially generate returns in times of turmoil. Below we examine how alternative assets are faring during this global pandemic and which strategies we believe are poised for success.
Hedge Funds – Positioned to Protect Capital and Profit from Public Market Dislocations
Structurally, hedge funds have more flexible investment mandates than their benchmark-driven counterparts. They are designed to pivot quickly in order to generate strong risk-adjusted and uncorrelated returns over a market cycle. Most hedge funds focus on protecting the downside first, as minimizing losses allows them to reinvest and compound capital at a higher rate.
There have been limited periods of prolonged market stress since the Global Financial Crisis, along with extended periods of historically low volatility as measured by the VIX. The opportunities for hedge funds to prove their worth have been few and far between over the last decade, until now, as fears stemming from the potential snowball effects of the COVID-19 outbreak have contributed to a global repricing of risk in both February and March.
In February, the MSCI ACWI Index fell 8.1 percent and the S&P 500 lost 8.23 percent. Even more noteworthy was the rapid pace of losses that came shortly after the S&P 500 reached an all-time high on February 19, 2020. That same month, the VIX Index surged from 13 to 40 before going as high as 82.7 in March.
Most hedge funds, however, more successfully navigated the tumultuous environment. In February, the HFRI Fund Weighted Composite Index and HFRI Fund of Funds Composite Index both lost less than 2 percent, and meaningfully outperformed global equities. In March, the MSCI ACWI and S&P 500 lost 13.2 percent and 12.4 percent respectively, while the HFRI Fund Weighted Composite and HFRI Fund of Funds Composite lost 5.9 percent and 4.9 percent respectively, protecting capital and generating alpha over public equities.
Although hedge fund performance, year-to-date, has varied widely across strategies, themes have emerged in our conversations with managers.
• In March, there was a significant dispersion in Equity Long Short managers, with outperformers taking defensive positions going into the month, often reducing leverage, covering short positions, adding broad index hedges and rotating into companies with stronger balance sheets.
• Discretionary Macro managers traded tactically with the increased market volatility. Not surprising, tail risk strategies and macro managers with long volatility positions performed well after years of negative to flat performance.
• Event Driven managers with large M&A books saw mark-to-market losses as deal spreads widened. It hurt performance for the quarter but allowed managers to take advantage of attractive asymmetric risk-reward opportunities. Event Driven managers also rotated away from soft-catalyst events and hedged the portfolio with single-name credit shorts in companies sensitive to even greater economic pressure and reduced demand.
• Fixed Income Relative Value managers saw extreme dislocations across rates and credit markets that caused many to stumble. This space, typically more levered than others, was under the most stress after funding markets seized in March. Cognizant the dislocations present trading opportunities, top-tier managers remain disciplined from a risk management perspective.
We include hedge funds in an investment portfolio as we believe there is potential to generate attractive returns while offering a measure of capital preservation during challenging economic and market conditions. The result has been uncorrelated returns with downside protection in periods of market stress. Given the dislocation and selloff across risk assets, significant alpha opportunities for hedge funds across strategies are expected as volatility remains elevated and the situation evolves.
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