Hedge fund styles underperform - More risk-taking will be required to make positive returns

You would not think some hedge funds would be down so significantly for September returns given that the major stock index (SPX) moved higher, but upheaval in small cap, value and growth harmed the average equity hedge fund. There were some positive gains in relative value managers, but it was a generally a tough month for those trying to actively find returns.

With a quarter to go in 2018, there will have to be more aggressive risk-taking to get hedge fund managers in the black. While the average hedge fund may be dong better than long bond funds, most investors did not buy hedge funds as bond substitute but as alpha generators. Research on money managers show a change in behavior in the last months of the year based on relative performance. Winners will take risk off the table and losers may push their risk exposure.

Managed futures down for month but within the range of performance for other asset classes

Managed futures, as measured by the SocGen CTA index, showed a slight decline in return for the month, but this performance within the range of most asset classes with the exception of equities. Being long market beta is still king for the year with little absolute performance value from diversification. 

Managed futures, in general, may have been able to exploit trend opportunities in bonds, rates, and energy based on our assessment of market behavior in September; nevertheless, the mixed range of price action during the first half of the month may have limited return potential. Managed futures have shown similar performance against a diversified portfolio of risk premia which have suffered from the sharp corrections in volatility earlier in the year.

With only a quarter of the year left, strong positive gains for managed futures will be dependent on some form of market dislocation that will spill-over to the large traditional assets. While many have noted there are asset price excesses in both equities and bonds, there is limited information to suggest a market dislocation is imminent. 

Strong directional trends in bond, rates, and energy sectors

September was a slightly down return month for many trend-followers as the first half of the month was range bound. Our sector indicators showed most markets not having clear trends with only some slight directional tilts. During the month, the markets became more directional for bonds, rates and energy. The price action in these markets aligned with economic fundamentals. A combination of continued good economic news, higher inflation, and another Fed increase all point to negative fixed income markets not just in the US but across all developed markets. Equity market signals were less clear-cut as the combination of higher rates and strong economic growth generated crosscurrents that were less clear. Cash flows should be higher, but the discount rates are also higher. 

Energy markets moved higher across the board as both crude and natural gas are suggesting upward trends. The dollar has started to move higher based on rate differentials and growth. Metals and commodities show more mixed directional bets. Overall, trend opportunities in financials look to be positive for October.

September Performance - Normalization After the Extremes of the Summer

September represented a reversal of some return extremes in US markets. With growth, value, and small cap all down more than 2 percent and large caps gaining, some of the extremes in US equity markets this year started to close. Perhaps the continued rising rates are starting to be discounted in levered companies. Long-term Treasury returns were down over 2.50 percent for the month. 

The big divergent between US and global equity markets still exists. The difference between SPY and EFA is just under 12 percent while the difference between US and EM equity returns are just over 18 percent. This gap has been one of the key themes in the post Financial Crisis period. It may close given the differences in global valuations, but there are a number of paths that may drive this convergence. 

While long-term bonds declined, shorter-term credit assets were mixed. High yield was positive for the month, yet investment grade bonds continued their slide. EM bond returns were higher on the post crisis bounce after the upheavals in Turkey and Argentina. International bonds were helped by the dollar decline. Commodities were higher on further gains in crude oil.

As we move to the final quarter of 2018, our biggest concern is credit. With rates continuing to move higher, the effect of higher interest rates will start to impact debt financing, or simply put, there is a lot of debt that will have to be refinanced at higher levels in the coming year. Rising rates will have a direct impact on corporate income and will also affect consumer purchasing. Inflation is close to the magic 2 percent number and the economy is at full employment, so there is no reason to expect the Fed to change policy direction. The excesses of the last three quarters are unlikely to continue, so an earnings normalization should be expected which will be bad for stocks.