Strong first quarter returns for selected alternative risk premia

Selected alternative risk premia showed strong performance during the first quarter. There is significant tracking error with the HFR risk premium indices versus individual bank risk premia swaps, but they can provide some suggestive rankings. This strong performance should not be surprising given the large reversal of with equity beta and the strong moves in global bond markets. A couple of major themes emerged for the first quarter centered around positive equity beta risk and falling volatility. 

Volatility strategies that do better when volatility is normalized after a spike performed well. Given the link between ARP performance and volatility, the declines since December were good for these indices. Concentrated risks in credit also did well as spreads declined significantly with the reversal in equity market risk. Carry strategies that are often correlated with equity market risk and volatility also performed well. Momentum long/short neutral strategies were hurt from rising short returns and rotation across sectors. Long-only momentum (smart beta strategies) performed better in the first quarter. A stable environment for the second quarter should allow risk premia strategies to generate further returns.

With market risk, so goes hedge fund performance

Hedge fund performance was dominated by the exposure to market risk as those fundamental equity funds that held more market risk dominated style performance. However, the average returns mask the large dispersion across styles. We still use indices for analysis because it does provide some information on what the average investor may expect. For example, while CTAs were down, on average, for the first quarter, anecdotal evidence from managers sending me reports show some up in the double digits for the first quarter. Winners made big money in the last quarter.

Call it luck or call it skill, the huge differences in performance were based on two key factors - one, long equity beta exposure going into the new year, and two, long fixed income exposure globally especially in March. Faster models made money. Discretionary traders who pounced on the changes in central bank thinking, or those who over-weighted fixed income were winners. If you got those two trades right, you made your year in three months. If you missed this or were late to the party, you are playing catch-up and having calls to explain performance to clients. 

A dirty secret for hedge fund management is that investors don't want any hedges during big market up moves, they want performance. Underperformance during large market beta moves requires an explanation from managers.

Equity Factor Performance in 2019 - Clustering of Returns

An analysis of the first quarter tells us a lot abut factor investing in the short-run. Foremost, the worst factors last year are the best for this year. Factor risks change with the market environment as shown through the global factor indices from S&P Dow Jones. Factor rotation occurs, but not clear that it is predictable. Factors effects also can be swamped by the impact of large macro events. 

Additionally, the relative gain or loss through investing in factors over time can be range bound when there is not a turning point in the business cycle. The value of factor diversification will be appreciated during periods of dislocation.

March - The big rotation from stocks to bonds

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“Do the central bankers know something I don’t know? 

Is the global economy worse than I think?”

March was about asset class rotation from equity to bond demand with fixed income significantly out performing equities in March. Markets have moved from the January monetary euphoria to something more cautious and questioning. If the Fed potentially put all rate rises on hold for 2019 and the ECB is delaying a course on normalization, do they know something I don’t know?

Certainly, there has been softness in a wide range of economic data which is inconsistent with strong risk-on behavior. Nevertheless, the almost complete reversal of forward guidance could be something that is a greater warning sign. Central banks are showing nervousness about the economy and this has spilled over to bond markets. The second quarter could be a time of strong equity reversals as markets normalize to a slower growth economy.

Our key policy statistic worth watching is real money growth. It has slowed significantly and now hovers around zero growth in the US. It is one thing to stop raising rates, but it is another to have money growth at extremely low levels relative to the post Financial Crisis period. Tighter money from last year is working its way through the credit economy and is a macro shock. Money growth may have been excessive before the Fed started raising rates, but weaning an economy off financial excesses is a difficult process and will have real effects.