Man FRM Early View - April 2020

An epidemic of unknowns: The challenge of managing portfolios, controlling risk and making returns amid multiple dimensions of uncertainty.


Goodness. So much that one might say, and so little of it any use.

That basic investment injunction to maximise prospective returns once they have been adjusted for the probability and magnitude of their possible failure wants us to minimise exposure to the unknowns, the unknown unknowns, the unknowables, the random, the loose reasoning, the prejudices and wishful thinking, the sense of what ought-to-be over, the sense of what-will-be, etc. (It absolutely hates that plank of the educational system that encourages us to ‘have a go’ when we haven’t a clue.)

Right now, we are all having a go at epidemiology. To be fair, more people seem willing to express their unmodulated opinions on this subject than they are willing to commit the safety of their lives or capital to them. Sentences these days may often start ‘but surely…’, but they usually end with a question mark. We are trying to be economists, too, for the first time in a decade. A ‘V’? A ‘U’? An ‘L’? Don’t know. Maybe more likely a ‘U’ than anything else, but the length of the base of the ‘U’ is both critical and unknowable. Arguments from historical comparisons seem more than usually hopeless. We remember 2008 pretty well: it was five months from the Lehman shock to the equity market bottom. Thanks.

It’s so hopeless because so many of the things we don’t know are so huge. Do we get a second wave of Covid infections when we are unlocked? What is the right trade-off between life and money anyway? (Whose money and whose life?) How long can you lock populations down before they break out? How will we behave, when we get out, blinking in the sunlight? How long before an effective vaccine can change our approach? Will right wing politicians continue to enact left wing policy? Will companies be allowed to continue to pay so little tax? …to run so financially geared? …to run so operationally geared? How strong is the anti-globalisation impulse from all this? It’s not just a problem of finding a number to plug into a model; we wouldn’t know which model to plug it into.

Everyone was shocked to see how much it cost to prop up the banks in 2008. Well, the fragility of the whole economic system we inhabit is orders of magnitude worse if the amounts of money required to maintain it on life support for a couple of months are anything to go by. Speaking of all that money, do we really know what money is? Is it more like a factual kind-of-a-thing or a fictional kind-of-thing? Will it Deflate or Inflate? We’re having trouble with the sign, never mind the magnitude. Whatever this stuff really is, we need to know if there is enough of it to bail out a collapse in the real global economy of unknown length and unprecedented severity.

But even if we did truly know the markets we operate in, like ‘Credit’ – the revolvers, the covenants, the liens, the wrinkles, all that - you probably couldn’t know that God is suddenly going to show up supporting the fallen angels. Acts of God are still firmly on the risk side of the equation…mostly. (By the way, in the quiet of the night, what does God think about moral hazards and efficient markets hypotheses?)

So, all this consigns swathes of investment ‘skill’ to the Stygian gloom. If someone said he knew all the answers, would we believe him? Entrust him with our money? Pay him a fee? It seems like a hard time to be invested in hedge funds that only do fundamentals.

But many hedge funds don’t, and some skip predicting the real world as a determinant of prices altogether by just focusing on the prices themselves – they are ‘technical’ not ‘fundamental’. It seems perverse that markets can be predictable in a way that the real world is not; that there might be eminently sensible ways of managing money without being quite sure what it is, or what it’s worth. First, this may be because prices themselves crystalize outcomes which we can’t predict independently: a company at risk of default is far more likely to be at risk of default if its cost of borrowing rises to compensate lenders for this risk: some prices are inherently unstable.

Secondly, this may be because of the wonderfully paradoxical fact that under uncertainty, as market participants we behave in more predictable ways; the more uncertain we are about what to do, the more predictable our behaviour becomes. We believe in situations like this, momentum works. Most hedge funds with material, reasonably flexible and competently executed exposure to momentum across a sensibly diverse range of markets have done well in a time of crisis, again.

The claim to usefulness of such funds has been widely challenged in recent years: ‘the alpha’s all gone!’ Part of the problem, may have been the stability of markets: they weren’t trendy enough. Or, competition has made trends so noisy that the valuable trends are now only to be found in markets which are hard to access. We may hear a whole lot less of these complaints for a while.

And what Sharpe ratio should one ask of a diversifying asset anyway these days? Consultants, CIOs and Boards around the world must be feeling queasy at the failure of Bunds to make any upside progress with equities down by a quarter over the crisis. We must all have felt queasy about BTPs these last few weeks. And, if not bonds as diversifiers anymore, then why bonds at all? And do we really need a liability matching industry with bonds here?

Who needs bonds when you can buy hedge funds? Simply put, two very common precepts in the technical trading world look as robust as anything now. They have worked well recently both in the Long-Short space and also in the land of Long-Only. First, run gains, cut losses. If we are to see very big moves (which to us is a base case), this one should act to point the book in the right direction for them at least. Second, adjust market exposure inversely to market risks. We believe that if markets go up, volatility will likely fall, so market exposures will tend to be increased in rising markets, but shrunk if we sink back. It may even be true, so maybe ‘that is all Ye know on earth, and all ye need to know’.

Hedge Funds

Hedge fund returns recovered from a difficult March to post positive numbers for April as a whole. The largest areas of gains were from Equity Long-Short managers with a material net long bias to rising markets and from Credit managers, who also benefited from a recovery in the asset class. Elsewhere, Relative Value managers saw a modest recovery from the stressed levels of intra-market spreads, which generally led to gains, whereas Macro managers were mixed as markets displayed a range of momentum and reversionary behaviours across different asset classes.

The recovery in equity markets was notable in those Equity Long-Short managers who maintain a positive net exposure to the market. The differentiation in returns in this strategy can largely be explained by those who were able to maintain the market exposure during the worst of the sell-off in March and thereby benefit from the bounce.

The alpha side of the equation for these managers (and for market neutral Equity Long-Short and equity-driven Alternative Risk Premia) was an altogether more complex affair. In general, the cross-sectional momentum factor performed well through the first three weeks of April, meaning that managers who looked to rotate their portfolios in more of a ‘value’ trade (i.e. buying the most beat-up stocks and shorting the outperformers) generally did poorly in the early part of April. Conversely, those managers with a longer time horizon to their strategies, focused on multi-year winners and losers, typically maintained their cross-sectional momentum bias and performed better.

However, the last four days of the month saw a significant reversal in this factor landscape, with material underperformance of cross-sectional momentum, and a very positive bounce in the value factor. As a result, the portion of managers’ returns attributable to factors was very volatile in the final part of the month. Another factor story affecting equity-focused hedge funds in April was the performance of large caps versus small caps. The first half of the month saw large caps outperforming small caps on a near-daily basis, whereas the second half saw this phenomenon reverse markedly. This high level of factor volatility may be driven by thinner than usual volumes in equity markets and a higher frequency of rebalancing/repositioning in the books of active market participants, possibly driven by risk management and/or investor flows.

The Credit landscape was generally very positive for hedge funds in April, precipitated by the willingness of the Federal Reserve to buy corporate debt securities to support the market. Many banks’ research desks have now significantly reduced their expectations around the size of the peak of defaults in this recessionary cycle. Such confidence in predicting the shape of the corporate impact of the Coronavirus is not a sign of any particular foresight in the development of the crisis from here, but more they believe that central banks will do all they can to minimise the real economic impact. In general, managers exposed to more liquid securities higher in the capital structure have recovered more quickly, whereas less liquid names and more distressed securities remain a longer term opportunity.

Relative Value was the epicentre of many of the difficulties for the hedge fund industry in March, and there has been less of a recovery in most spreads than one might have suspected given the apparent ‘risk-on’ behaviour of headline equity and credit indices. Average asset-weighted merger spreads have only narrowed slightly during the month of April, despite the closure (and breaks) of some of the larger deals in the space. Other parts of the liquid Relative Value landscape, such as index arbitrage and holding-company arbitrage have also seen small positive gains, but generally these are as yet insufficient to offset the losses seen in March.

Macro managers had a more mixed month in April, with a sharp trend reversal in equities hurting CTA managers who had become materially net short equities by the end of March. However, in general managers benefited from the continued chaos in Oil markets as prices across the curve declined for most of the month, although there was a recovery in Oil prices during the final week of the month which generally hurt trend-followers. It is worth noting that the extreme moves seen in the front month WTI Oil contract on the 20th April had relatively little impact on the majority of hedge fund managers, as Macro managers typically roll their exposure a few days ahead of contract expiry. Elsewhere, Macro managers had mixed but generally positive performance in government bonds and FX.