Trends for June - Up for equities and bonds

May was a mixed month for many trend-followers. Some did well while others got caught on the wrong side of mid-month reversals. The month saw a mid-month equity sell-off which could have stopped-out a number of key positions in equities and bonds. This sell-off was based on political uncertainty and not macro fundamentals.

While volatility was reaching multi-year lows, there was still risk in the markets through short-term rapid changes and trend reversals. The second half of the month started to show some better trends which may be profitable in June. Nevertheless, we are concerned that the usual negative correlation between bonds and stocks does not seem to present. Both equities and bonds are trending higher. One could argue that this is a result of lower inflation expectations, but we fear that equity and bond traders have different expectations on growth. Equity optimism and bond pessimism cannot both be right.  

The dollar has again started to move lower which is a continuation of the longer-term trend for year. Precious metals have moved higher with the dollar decline. There is a renewed down trend in energy prices, but many of the other commodity markets have no clear trend direction. 

Right now, the financial sectors offer the best opportunities albeit muted given the lower volatility across many markets. Our largest concern is that volatility spikes may cause positions to be lost in a muted trend environment.

Hedge fund behavior consistent with major asset classes

Many hedge styles are generally tied to the direction of equity markets, albeit at lower beta. Hence as the equity markets go, so go equity hedge funds. Similarly, relative value will be affected by correlation and volatility in equity markets. If markets are correlated and have lower volatility, then there is less opportunity in relative value. There is less stretch in the market. 

May was a difficult market for hedge funds that are more focused on small cap and value stocks given the poor performance for these indices this month; nevertheless, hedge funds styles have generated positive returns for the year. The only exceptions have been global macro and CTA's. Interestingly, these are two styles that have been classified as crisis risk offsets. In simple terms, if there are no crises, these strategies may underperform. They will make the greatest returns when there are market divergences. While these two strategies are absolute return managers, we generally find that larger market dislocations across many markets will be more favorable for return generation. 

As we reach the mid-point in the year, we have mixed views on the performance of hedge funds. While generally positive, it seems as though managers have not been able to capitalize on the strong equity performance around many global markets, and have missed the weakening in the dollar, Political noise seems to have dampened risk-taking and without risk exposures, there will not be returns.

Managed futures - All dressed up but not going anywhere

Money has flowed into managed futures under anticipation that there will be a crisis event that will need the diversification benefits of trend-following strategies. These investors adjusted portfolios away from perceived overvalued assets to the value from long-short diversified trend-following. What is the sense of increasing allocations after the divergent event of a equity sell-off? 

The only thing that is missing is the crisis event. There is now the waiting for the event. However, let's not forget that crises are by definition unexpected, and the value of trend-following is not with their ability to predict these crises. Systematic trend-following is non-predictive; nevertheless, given risk management which will exit losing positions and the ability to dispassionately enter new positions, trend-followers should adjust to a divergent crisis quickly and should be able to exploit an extended decline.  

The problem is that forward-looking investors are ready, the strategy is ready, but the markets have decided to continue to move in directions that do not allow managed futures to profit. This month was almost the same as last month with respect to equity and managed futures behavior. A representative index shows flat performance and equities have continued to march higher.  There are manager winners and losers this month, but generally, opportunities have not been exploited. Although the dollar declined, commodities in general were lower, stocks trended higher and bonds were up, managers have not found strong opportunities which translate to higher returns.

The 12-month rolling returns show managed futures consistent with long duration Treasury (the other main crisis offset tool) performance. There is an opportunity cost for those who have sold equities and bought managed futures over the last year. We will have to wait and see if the early allocation changes will be rewarded. 

Asset class performance - The "Global Rotation"

Call it the "Global Rotation", but last month was a continuation of what we have seen for the year. There has been a flow of money into international stocks and increasing divergence between the rest of the globe and US risky assets. There is a dollar adjustment component to these returns, but there is no mistake that there is a preference for cheaper opportunities around the world. 

Using a simple adjustment based on the DXY dollar index, the local returns should be moved down by over 2 percent which would have put returns closer to large cap US. The dollar has fallen about 5 percent since the beginning of the year which places global returns more in-line with large cap US. However, the switch from small cap and value in the US to other parts of the world is unmistakable along with the switch to large cap in the US. 

Bonds posted strong gains both for duration and credit for the month. With a smaller probability of any inflation overshoot and monetary policy which seems to be measured, there is stronger demand for fixed income. This is more muted around the rest of the world after accounting for the move in the dollar. Commodities continue to slide and are the asset class laggard.