Where do hedge fund investors want to put their money?

The demand for hedge funds continues. The recently released 2016 Credit Suisse hedge fund investor survey shows that over 80% of investors plan to maintain or increase their allocations to hedge funds this year. The survey also ranked the most popular hedge fund strategies as measured by their net demand. Equity market neutral filled the top two spots and equity long/short grabbed two of the top five positions. The only strategy that was outside of equity trading was global macro discretionary.

I find this very interesting because equity market neutral is really an attempt to gain the risk free rate of return plus alpha. We know the risk-free rate is still hovering close to zero, so you need to chase alpha. More money will be looking for the same set of opportunities. Markets may not be efficient, but we do know they are competitive and that easy market entry into an inefficiency will drive excess returns lower. The only reason to invest in market neutral is that you believe that there will be growing alpha opportunities that will match or exceed the extra cash moving into this style.

The long/short equity strategies are trying to do the same thing but with some variable beta exposure. You get the risk-free rate of return plus some beta and any alpha the manager can find. It is like holding equity plus cash in proportion to the amount of beta in the portfolio plus alpha on the equity trading. You may argue that is not the case, but it may be a close first approximation. 

The global macro discretionary may be the only strategy in the top five which may give you a chance  of gaining some unique diversification by looking at a wider range of investment alternatives. We have written before about the return profile of hedge funds in our post: 

What are you really buying with hedge funds? Put writing?

Most hedge funds have pay-offs similar to put writing. Managed futures and global macro will give you something different - divergent trading which produces positive convexity. It seems odd that at the current high level of uncertainty most investors want to stay close to the comfort zone of equity trading.

Managed futures sector review - sectors trend CTA's make money

Often times you will hear managed futures managers discuss the markets they made money in, but the really relevant issue is whether they were able to exploit trends in a sector. Trend-followers need to capture sector trends, or more bluntly, there have to be sector trends that managers can exploit. Hence, we have developed a simple table of sectors, their recent direction, and the macro signal that is coming from these prices. 

We look at a trend indicator for each major market within a sector and average the simple direction signals to form a sector  up or down indicator to show sector trend. For example, we look at a set of stock indices around the world which show all are now in major up trends. For bonds, we look at all major global bond markets as well as the different futures markets along the yield curve. Here the story is mixed with US markets rolling over from their up trend but the EU continuing to trend higher. 

We also discuss what the prices are indicating as a macro signal. In particular, we are focused on whether the trends are consistent with macro fundamentals or the story that is currently being told in the marketplace. For example, oil prices have been trending higher, but the stories and data on full storage and limited production declines still dominate the news. There is a divergence between prices and fundamentals. We cannot say which is right, but we can say that this is an area of potential risk.

Just because a sector seems to be trending does not mean that all managed futures managers will make money, but we believe it provides a good indicator of whether the environment is trend rich. If there are significant trend reversals or if the sector shows mixed behavior, we would expect flat or negative performance. Right now, the indicators are showing a good environment. 

Managed futures and global macro hedge funds the leaders for the year

Although US equities rallied in the second half of the month to almost get to flat returns for February, hedge funds in most cases were not able to generate positive gains. The exception was managed futures which generated strong monthly gains and easily beat other hedge fund alternatives. The only two other positive gainers for the month were global macro and special situations which is a catch-all category. 

Hedge funds should not be expected to track short-term changes in equities or bonds. Their beta exposure is significantly less and in the range of .3 to .6 versus the S&P 500; nevertheless, during periods of poor performance hedge funds should be muting the loses. To a degree they have been doing that so far this year. The combination of January and February for the HFR Global Index and Equal Weighted Indices have outperformed an equity portfolio, but many individual strategies have simply missed the mark. 

The managed futures and global macro indices were the only two that have generated back to back positive returns for the first two months of the year. Managed futures has proved to be the most unique strategy, something we have continually discussed. As a divergent strategy, managed futures will do well when there are strong market dislocation. In contrast, most hedge funds have convergent strategies which do well when markets are more range-bound are moving back to equilibrium after a dislocation. 

The first two months of 2016 can clearly be characterized by major market dislocations. A good environment for managed futures. Can we say that this will continue going forward? It may be difficult to predict which style will do well in the short-run. This is one of the key reasons why holding a diversified portfolio of hedge fund styles makes sense. Nonetheless, there should be clear overweight to the styles that are most unique.

Managed futures still delivering in February

The SocGen CTA index gained 2.89 percent for February and the SocGen Short-term Traders index posted an increase of 2.88 percent for the month. Both indices are solidly positive with 7.19 and 6.47 percent gains for the the year. Managed futures were able to post gains in spite of a reversal in equities to the upside and a stalled bond rally near the end of the month.

Even with the reversal in equity fortunes based expectations of better US growth and continued monetary liquidity around the globe, US equities are down 5 percent for the year. The return differential between equites and managed futures is now double digit. This advantage is even greater for global equities. The Barclays Aggregate bond index is the most often used benchmark for institutional investors. Its returns are more muted than the long bond because of its heavy skew toward mortgages and credit. Managed futures is outpacing this key bond index by 5 percent.

Long bond exposure would have done better over the last two months, but investors would have been taking undiversified risk where the benefit is highly related to the negative correlation between stock and bonds. While the long bond has been the chief diversifier for most investors over the last few years, there is no guarantee that the negative correlation with stocks will continue. There may be further flight to safety, but that only pushes bond risk forward as rates move to lower levels. 

Most managed futures funds were able to exploit opportunities across asset classes with gains in equity indices for the first part of the month, bonds, commodities, and selected currencies. Returns will become muted if major trends stall. There may be trend transitions in March but gradual slowing in momentum may allow traders to adjust portfolios. The March FOMC meeting will be a transition point for macro traders.