Alternative Markets Review 2018
2018 started as strongly as it finished in 2017, but spikes in volatility caught hedge funds unprepared and highlighted the weaknesses of the industry. The rest of the year continued in the same pattern with major political risks adding to the problem such as Brexit outcome, European elections, end of quantitative easing and trade war. The fourth quarter and equities sell-off since October ruined hedge funds hopes to rebound and sank them deeper into their losses. Event-driven and equity hedge strategies were the worst performers among hedge funds, followed by systematic CTA and macro strategies. For our in-house strategies, the scenery was slightly altered as the worst performing asset class was tactical trading. Underperformance of cryptocurrency and CTAs are the main drivers of the underperformance compared to other indices, despite the strong performance of our global macro and market neutral strategies. Equities globally suffered severe losses, similar to the majority of our in-house strategies. Our niche equity strategies focusing on disruptive techno-
logies and directors' dealing though posted strong returns and constitute our best two performing strategies for 2018, consequently leading to a relative outperformance of peer indices. Direct lending and structured credit enjoyed a good year assisting in our credit index's outperformance. Only two out of eight strategies posted losses for a year, when equity and credit largely disappointed their investors. Overall, our cross-asset and single manager index posted losses for the year due to our tactical trading underperformance, but still performed better than the majority of the individual indices.
Hedge funds started 2017 under pressure and the overall industry’s model was in question. Performance and fees were the main topic of debate among investors at the beginning of the year, but hedge funds managed to pull a strong year with no down month. Despite losses from some large managers, the industry overall generated strong returns according to HFR data attracting more capital. Per HFR, total hedge fund industry AuM increased by $59bn to $3.21tr, the sixth consecutive quarterly record for total industry AuM. The inflows suggest a sign of regained optimism, but the industry will need to sustain its performance long-term in order to regain its calibre. The oxymoron of the industry is the fact that equity hedge were the best performing strategies amongst hedge funds but suffered the biggest outflows. Macro, CTAs and multi-strategy attracted more capital this year, and given the outlook for more volatility and less central bank intervention, investors target further allocations in those sub-sectors.
Stone Mountain Capital Strategies
2017 was the year producing the strongest return for hedge funds since 2013 and second best since 2009. Stone Mountain Capital strategies outperformed in last year’s environment across all asset classes. Credit was the only strategy underperforming its peers, caused by yield compression in the direct lending space. One, out of only three negative strategies was in credit, while the other two, were CTAs that struggled amid the low volatility and trendless environment. Despite these two strategies, tactical trading was overall the best performing strategy with strong returns generated by discretionary global macro and cryptocurrency. Equities enjoyed a very profitable year and Stone Mountain Capital’s mandated equity hedge managers produced astonishing returns, beating their traditional and alternative peers. Finally, fund of hedge funds recovered from their 2016 losses, surviving while the industry’s model is evolving.
Figure 3. Stone Mountain Capital In-House Indices vs. Major Benchmark Indices Hedge Funds and Long Only in 2017, Stone Mountain Capital Research; SMC strategy indices are not investable products but are used as indication of our managers' performance and are calculated with the equally-weighted method.
STONE MOUNTAIN CAPITAL RESEARCH PERSPECTIVE VOL.45
The new era of presidency in the U.S. is marked with significant changes, with the Treasury Secretary announcing tax reforms in the next six months and the FED ready to increase rates. Hedge funds have momentum and they extended their January gains into February, with CTAs posting the biggest returns according to HFRX index. Equity hedge, macro and event-driven strategies exhibited similar robust performance and proving that they overcame last year’s underperformance and they gaze into the future with confidence. A Preqin survey evidence a large increase in the number of alternative investors and the performance of alternative asset classes is encouraging for the future of the industry. In debt markets, the risk retention regime leads to lower volumes in CLO issuance and fewer deals. There is an increasing appetite for private debt strategies and the economic outlook may suggest a growth in commitments over the next two years. There are more funds focusing on European credit, which is indicative of the opportunities in the space amid a relatively uncertain political scenery. Private equity fundraising continues in solid pace, while competition for deals is increasing rapidly alongside the number of funds in the market. Adding hedge funds, that compete for similar deals, makes the identification of opportunities even harder. Both private debt and equity strategies focus on the mid-market spectrum as the opportunities there are more attractive. The same scenery prevails in real estate industry with high prices and increased competition being the main feature. The investment activity slowed down and the macro outlook with interest rate growth expectations and political uncertainty are the most significant drivers behind the slowdown.
STONE MOUNTAIN CAPITAL RESEARCH PERSPECTIVE VOL.43 JANUARY 2017
2016 was a landmark year for the financial world because of a series of events that shaped a new reality. Last year was marked by major geopolitical events such as, U.S. elections and rumours about Russia’s interference, Brexit, Italian referendum, the Turkish coup, missile tests from North Korea and terrorism. These events combined with the low-interest rates environment in major developed economies and the continuation of monetary policies created a volatile scenery. Amid this environment, hedge funds performed well for their investors. After a disappointing beginning in 2016, they managed to turnaround the situation. Hedge funds got hit hard in the first two months of 2016 by the uncertainty about Chinese and other emerging market economies and by the drop in oil prices. The slow economic activity continued in February as the Brexit talks were intensified amid an underperformance of emerging markets, which led to volatility and losses in equities. CTAs were the only strategies performing well, but in March a reversal of this scenery was witnessed. Emerging markets resurrected, oil and commodities recovered, while the U.S. dollar lost to all major currencies. The increase in implied volatility and the tightening of spreads led to gains for relative value strategies in April, which was the month of some of the biggest pension funds’ exodus from the asset class. After that, a whole discussion was initiated regarding hedge fund fees and performance, putting more pressure on managers. During May and June, hedge funds were continuing their positive trend, still trying to recover from the poor first two months of the year, with Bitcoin rallying and being the biggest winner in the currencies war. July was the month of Brexit and when Germany became the second G-7 nation to issue negative yielding bonds. August was a quiet month, but September found investors worried about the policies in US and Europe, as FED members appeared to have dichotomous views and ECB alongside BoE continuing their QE practices. October found event-driven hedge funds in the top of the table in terms of performance, while CTAs found themselves in negative territories and the rest of the industry was trying to restore investors’ confidence and maintain their assets. The outcome of the U.S. elections in November created a sentiment of economic growth and structured credit strategies revived in the anticipation of deregulation. This outcome also benefited bitcoin, which enjoyed a rally in November and finished 2016 in an emphatic way with an increase more than 115% in its price overall. Meanwhile, direct lending and distressed debt strategies were attracting more and more institutional money in the hunt for yield from investors. The truly uncorrelated alternative income strategies are the solution to the yield problem and investors shifted from traditional fixed income strategies to alternatives. Deloitte’s Alternative Lender tracker noticed an increase in the deal flow in the private credit space and the momentum in 2016 favoured private debt funds, with the biggest brands in private equity creating private debt departments. Hedge funds completed their full recovery in December posting gains in a challenging year. They are preparing for an exciting year for active investing during 2017. According to Preqin, private equity buyout deals fell in 2016, with most of them being in the U.S. and then Europe was following. Alternatives had an interesting and challenging year and boosted their popularity amongst institutional investors, who are targeting to increase their allocations over the years to come.
STONE MOUNTAIN CAPITAL RESEARCH PERSPECTIVE VOL.42 MID JANUARY 2017
In 2017, a similar economic scenery is expected as during 2016 in an extension of the current economic cycle, and this year will be a transitory year towards a potentially unprecedented geopolitical and economic environment. This uncertainty will give rise to active investing and dynamic asset allocation with alternatives being the most attractive choice for investors. Trump’s election and Brexit belong to the past and the upcoming elections in Europe and the highly anticipated rate rises in the U.S. are going to attract a lot of investors’ attention this year. There are new risks on the horizon and investors are called to make wise choices regarding their allocations to avoid these risks and profit from them. Hedge funds have a bright outlook in 2017 after reversing the bad start in 2016 and finishing strong. The higher anticipated volatility in the markets creates opportunities for alpha-pursuing strategies across the major asset classes. Credit/fixed income strategies with short duration are expected to perform better in the space as most investors are looking for alternative income strategies such as direct lending or real estate debt. Emerging market debt enjoyed an amazing year 2016, but the rising U.S. dollar could make things worse for them this year, but there are still some very attractive opportunities. The forecasted U.S. economic growth, global inflation and a potential increase in bond yields will turn investors’ attention to sector-focused funds, systematic equity algorithmic strategies and niche strategies around U.S. equities. European equities could also offer investors with opportunities as there were outflows from European markets amid the turbulent political scenery. On the short-term, market neutral strategies could play an important role to every portfolio until the political scenery starts clearing out. Tactical trading strategies are the most exciting as volatility in the markets is about to surge, and volatility and CTA strategies are positioning themselves accordingly to profit from this environment. Discretionary Macro strategies have a ton of opportunities across asset classes with rates, currencies, commodities and emerging markets being the most lucrative. Finally, Bitcoin is expected to continue the rally it experienced in 2016 with major sovereign economies ready to accept it as addition to the U.S. dollar and a storage of value comparable to gold. The market capitalization of bitcoin is at an all-time high and bitcoin is competing fiercely and profitably with currencies and commodities as the best performing asset class during 2016. Fund of hedge funds struggled in 2016 and 2017 will make no difference as investors turn their focus to multi-strategy funds around credit and equity. Overall, there is a confident feeling on hedge funds with outflows to be limited and new investors ready to explore this asset class in their chase for uncorrelated returns. Private debt in 2017 will continue the momentum of last the years with increased deal flow and competition in both the sides of the Atlantic. The most intriguing feature of this asset class is the uncorrelated alpha generated combined with low volatility. In 2016 it outperformed both equites and credit. Volcker rule, Dodd-Frank, Solvency II, Basel III & IV, rising rates, risk retention rules deadline and central banks’ policies make the asset class extremely attractive. The asset class will attract more traditional fixed income investors as they are looking for alternative income strategies globally. Direct lending is the sub-strategy that will allure huge interest because it provides downside protection, access to attractive middle-market loans and a diversification effect to every portfolio. Direct lending in Europe is still an under-developed asset class and proper loan selection and sourcing could generate very attractive value, whereby investors should focus on sector and regional lending strategies. In private equity, there is huge demand for quality assets, but the struggle this year will be the high valuations. The volumes of PE transactions could increase due to the Volcker rule and investors are looking for best-ideas portfolios. The concept is similar to private debt in terms of opportunities as most European mid-cap companies have difficulties in accessing capital. Overall, 2017 appears to be an exciting year for alternative investments amid a very uncertain environment. The strategies that look promising this year are direct lending strategies in the U.S. and Europe, CTAs, global macro, volatility and bitcoin as we identify more space for opportunities.