Foreword

2020 was most certainly an unforgettable year, no matter how many of us may wish we could. It tested patience, Zoom know-how and, in the hedge-fund world, resilience. On this point, our approved hedge-fund managers did a very good job of limiting losses in the first quarter and, as the pandemic wore on, generating strong returns as both markets and investor behavior normalized.

Fortunately, within the hedge-fund space, 2020 ended on a high note. The HFR 500 Index, a proxy for the broader hedge-fund investment universe, for example, finished the year up 10.4%. In particular, the response to successful Covid-19 vaccine trials in the fourth quarter saw markets rally. Investor confidence soared as hope for mass immunizations in the first half of 2021 and a resultant, much-awaited return to “normal” economic activity looked possible. However, caution should be applied as the we will only begin to see the true economic impact of the Covid-19-related shutdowns as economies start to reopen once again. 

With this in mind, we have made two key changes to our hedge-fund outlook. Firstly, we upgraded event-driven merger arbitrage to positive. We attribute this improved view to attractive pricing on several deals, as well as significant optionality on future deals related to the special purpose acquisition company (SPAC) market. On the flip side, we downgraded our outlook for relative value fixed income sovereign to neutral. Normalization of the opportunity set related to USD cash versus futures-basis trading prompted this change.

In our view, the overall 2021 outlook for hedge funds is attractive, on both a relative and absolute basis. After years of waiting in the shadows of other investments classes, hedge funds are beginning to catch allocators’ eyes. Whether this is a function of not-so-attractive bond yields or seemingly stretched equity valuations, the fact is that few investment classes are able to offer the risk-adjusted returns we see from hedge funds right now. Today, a light is shining on the opportunity-rich backdrop that unconstrained investors may be able to benefit from.

Source: HFRI, ASI February 2021. Data range from 1/1/2005 – 2/28/2021. Past performance is not an indication of future results. For illustrative purposes only.

HFRI 500 Global Macro

Discretionary Thematic
Forward-looking rating: Positive

Our outlook for discretionary thematic remains positive. In a previous edition of our Hedge Fund Outlook, we highlighted our belief that following the U.S. election, Covid-19 would once again drive macro-manager positioning.

Now that the election has passed, we see this prediction playing out.  Depth of recession, ability to exit lockdowns and speed of recovery are highly divergent across countries and largely dependent on the timing and sequence of policy initiatives. We expect this to cause dispersion in price moves across regions and asset classes, potentially providing a breadth of trading opportunities for discretionary macro managers. As a result, we believe this environment will provide greater opportunities for directional, thematic macro managers with a bottom-up approach and managers with a relative-value bias. These two types of managers may be well-positioned to capitalize on divergences across regions and any emerging macroeconomic trends.

We believe the most robust opportunities may be in currencies, intra-curve and inter-country interest-rates trades (rather than purely directional trades) and selective opportunities in emerging markets (EMs) with strong fundamentals. Several factors come together to form a positive backdrop for EMs. These include: investors seeking yield, the expectation for a weakening U.S. dollar, a return to political normalcy in the U.S. and the cascading effects of a rebound in China, which will benefit other emerging markets.

Chart 2:  Variation among major markets may lead to uneven inoculation rates across DM and EM

Source: ASI, March 2021

Systematic Diversified
Forward-looking rating: Neutral

Our outlook for systematic diversified remains neutral. Because we believe that the Covid-19 crisis has driven global economic dispersion levels higher, we are concerned that asset prices and fundamental data may not exhibit stable trends in the first quarter of 2021. We therefore see more compelling opportunities in strategies with a short-term time horizon that can ebb and flow with whipsawing markets. We also expect multi-strategy systematic macro managers to outperform more fundamentally driven managers slightly over the near term. We believe this because price-based inputs will be the first to reflect changing market sentiment.

Manager positioning has become relatively stretched in equities, and risk-on exposures elsewhere in the portfolio — including EM currencies (versus a short in the U.S. dollar) and oil — have increased. We attribute this to bullish market moves, which have left managers relatively exposed to a change of market sentiment. Conviction in fixed income, which has historically driven systematic returns significantly, remains low, with managers currently expressing either moderate long or short exposure. As global monetary and fiscal policies become more clear, Covid-19 vaccines continue to roll out or the path of inflation across developed markets shifts, we could see the case for increasing the conviction in systematic strategies. Longer-term trends could potentially establish themselves across fundamental and price data.

HFRI 500 Equity Hedge

Equity Hedge
Forward-looking rating: Positive

We’ve become increasingly constructive on the outlook for equity long/short. The backdrop for the strategy, which was already improving in the last quarter of 2020, appears to have become even more compelling. The fourth quarter of 2020 and the beginning of 2021 have not been without challenges for equity long/short, particularly strict alpha-focused sub-strategies. In addition to an attractive alpha environment, we believe managed market beta may also contribute to equity long/short returns.

The outlook for equities as an asset class has become increasingly attractive. The pandemic sparked a prolonged period of economic stagnation. But now, enormous global fiscal and monetary support aimed at kick-starting the global economy has been put in place, bolstering the outlook for global growth. These economic and policy conditions also support corporate earnings and equities as a destination for flows.

Market beta then, in our view, may serve as a strong, positive driver of hedge fund manager returns. We prefer flexible net managers with a proven ability to combine top-down and bottom-up investment processes to capture a combination of the rich alpha and beta opportunities. This all said, we must remain mindful of risks to markets and long/short investing. These risks include:

• The ever-present danger of style rotations caused by extreme positioning and intra-market valuations
• Economic risks related to the virus, vaccines and reopening of the global economy
• Sharp reflation or bond yield shocks
• Further repercussions related to extreme retail trading, targeted short squeezes and consequential mass deleveraging

If this bull market is to be set against the backdrop of a more inflationary environment, it’s likely that it will look different to the last one. For instance, long duration growth assets and U.S. tech stocks might not be the predominant drivers of stock market returns as they have been for many years now. We believe there will remain an abundance of attractive long/short opportunities in technology driven by constant innovation and disruption. In light of this, we still favor technology, media telecom (TMT) long/short as a core sector specialist allocation. But the potential for new market leadership, or at least less concentrated leadership, may create opportunities in areas of the market that have lagged. Value and cyclical stocks may benefit from a rebalancing away from high-growth markets, and we are more agnostic toward managers across investment styles than we have been in recent years. Regionally, this new bull market could help reinvigorate markets that have been punished for their dependence on global economic growth, including Europe and Asia. We are excited about potential opportunities to increase exposure to those regions.

Thematically, there are a plethora of secular stories creating exciting long/short opportunities across regions and sectors. For instance, many managers speak of how pandemic-induced lockdowns have served to expedite disruptive secular themes that were already underway. These most obviously include the shift toward e-commerce and the technological advances that have enabled working from home. Managers are excited about the long and short alpha opportunities that the enduring behavioral and societal changes may bring. These shifts pervade most sectors directly or indirectly, though we view TMT and consumer long/short specialists as particularly well placed to capitalize on this growing opportunity set.

Elsewhere, enormous advances in molecular biology, genomic research, life science tools and diagnostics may create a multi-year wave of exciting new opportunities in healthcare investing. Similarly, the global push for decarbonization creates massive waves that will most likely touch all industries. Decarbonization efforts are already creating compelling opportunities across the energy, utilities and industrials sectors. We strongly believe that sector specialists who are best placed to exploit these trends may stand to benefit strongly. We are excited about the quality of specialists we see across many different sector verticals.

Source: Alliance Bernstein, ASI, March 2021

Event Driven

Activist
Forward-looking rating: Positive

We maintain a positive outlook for the activist strategy. Improved shareholder engagement remains an important topic for global policymakers, especially as global economies recover from the pandemic. Additionally, as passive investing continues to grow in popularity, we expect the engagement of traditional investment managers to continue to affect the balance of shareholder power. Index funds managed by firms such as BlackRock, State Street and Vanguard have larger ownership stakes and voting influence, i.e., a greater voice on governance and stewardship principles.

In the near term, we expect a sustained increase in new activist campaigns. We previously wrote that we saw a potential, strong opportunity for activist investing coming out of the global pandemic, and this holds true today. Activists used a somewhat condensed toolkit in the immediate aftermath of the Covid-19 surge in the first half of 2020. Now, they are employing a fuller suite of the tools available, driven by strong M&A momentum and capital return campaigns. Activist investors remain on the hunt for companies trading at levels that do not reflect their assessment of fundamental value.

Many companies continue to find themselves in a vulnerable state as buyer appetite continues to outweigh seller appetite, which could create an uptick in hostile activity. Activists were engaged with management teams and company boards behind-the-scenes in the earlier days of crisis recovery. But now, we expect to see an uptick in public campaigns as well, with the market generally rewarding news of newly disclosed stakes. A pick-up in M&A, supported by industry consolidation, as well as strategic buyers looking to take companies private, will lead to increased activism. M&A has become a popular tool for activists to create value because campaigns with M&A-related theses can be less risky than more uncertain, traditional turnarounds. Furthermore, they have shorter timeframes compared to traditional, operationally-led turnarounds.

Given the length of time managers typically require to implement their activist agendas, hedge-fund investors should consider any investment over a multi-year timeframe (at least three-five years). We see greater opportunity with managers who can maintain an active pipeline of new positions and employ a hedging strategy to offset any potential concentration risk.

Special situations
Forward-looking rating: Neutral

We maintain a neutral rating for special situations. ASI’s positive house view on U.S. equities supports the beta component of the strategy’s return, especially as markets have rebounded strongly following dislocation in March 2020. Currently, special-situation managers rely on beta to higher-quality names to generate returns. Many of these positions are in companies that have benefited from post-Covid behavioral shifts. However, as we saw last March, special-situation positions tend to have high hedge-fund ownership. Fund deleveraging and risk aversion in stressed periods can combine to put pressure on these crowded names, and remains a risk in the strategy. We have tempered our strategy outlook because special-situation managers tend to initiate positions in situations where the catalyst(s) may be softer in nature or have yet to play out. Further, we see extended timelines due to uncertainty surrounding the pandemic.

Looking ahead, a new set of catalysts have emerged as companies adjust to the “new normal” in the post-Covid world. This emergence of new catalysts should help special-situation managers generate more idiosyncratic and less beta-driven returns. Managers are also beginning to see a pick-up in opportunities, such as spin-offs, as companies look to create value.

Managers maintain positions in companies likely to experience Covid-related catalysts, categorized as “Covid-recovery” trades, including bets on travel, leisure, elective procedures, etc. These trades are more beta-driven as markets react to Covid news. Managers can take a short-term, tactical view of these positions or a longer-term “buy-and-hold” approach. To do this, managers may look to 2022 projections to determine which companies are temporarily undervalued versus those that are permanently impaired.

Merger arbitrage
Forward-looking rating: Positive

We have upgraded our outlook for merger arbitrage to positive. We were most worried about deal-break risk and re-investment risk in 2020 as global M&A volumes stalled with the rise of pandemic-induced uncertainty . In fact, the percentage of announced deals that failed jumped in May 2020 to levels last seen during the Global Financial Crisis (GFC).

However, large, transformational deals precipitated a huge spike in announced deal volumes in the second half of the year. In the second half of 2020, there was a record number of announced deals, spanning several sectors. Deals in the consumer, technology, financial and media/telecom sectors all exceeded 2019 volumes. We expect strong M&A activity to continue in 2021. Both continued sponsor-led M&A activity, which reached all-time highs in 2020, and hostile and unsolicited M&A, which was at an all-time low in 2020, but surged into year-end, will likely drive this activity.

Typically, a low interest rate and tight-spread environment would temper our return expectations for the strategy. However, many merger-arbitrage managers built dedicated special purpose acquisition company (SPAC) portfolios over the course of 2020 to take advantage of a steady flow of new issuance and in place of muted M&A activity. A diversified portfolio of SPACs, built near trust value, may have attractive deal-related optionality and minimal downside risk. This could complement a portfolio of announced M&A deals. SPACs accounted for significant portion of positive PnL across merger-arbitrage managers in 2020, and we expect this trend to continue.

Longer-term, sustained, high volatility and deal breaks are the biggest risks to the strategy. However, we like the defensiveness of merger arbitrage; it has historically performed well versus other hedge-fund strategies during volatile periods. Short bouts of volatility that cause spreads in announced deals to widen create opportunities for arbitrageurs, allowing them to deploy capital aggressively and take advantage of wider spread levels.

Source: Bloomberg, March 2021

Distressed
Forward-looking rating: Neutral

We maintain our neutral outlook for distressed strategies. The opportunity set narrowed considerably during the fourth quarter 2020 following:

• Positive Covid-19 vaccine news
• A “blue wave” in the U.S. election, indicating robust fiscal stimulus on the horizon
• Adjusted U.S. Federal Reserve policy, which emphasizes low employment over containing inflation, suggesting that rates will remain at zero for longer than in prior recoveries

This trifecta leads to lower default forecasts.

Despite our base-case scenario of a benign-default environment, the path of the recovery remains uncertain, particularly for Covid-sensitive sectors. While corporate credit spreads have generally returned to pre-pandemic tightness, the headline figures mask higher dispersion among the sectors. We think managers with expertise in travel, leisure, lodging, real estate and other severely impacted sectors will continue to have an outsized opportunity set in the year ahead.

Finally, we are constructive on the distressed international opportunity. Businesses across the developing world, from South America to Southeast Asia, face an extended timeline to community immunity. Emerging virus mutations may complicate this further. An unprecedented 83 sovereigns sought International Monetary Fund (IMF) financial assistance in 2020 and exited the year with significantly higher debt-to-GDP ratios. Three countries are in default (Lebanon, Zambia, Suriname) and two others defaulted and completed restructurings last year (Argentina, Ecuador). In Europe, many businesses may experience negative impacts from falling real estate values, a slump in tourism and even Brexit-related complications.

HFRI 500 Relative Value

We have downgraded our outlook in this space to neutral. We attribute this to the fact that the opportunity set for bond-basis trading in the U.S. has noticeably declined, while it remains average in Europe and Japan. The March and June futures contracts are relatively fairly priced, thanks primarily to abundant liquidity in the market and a strong backstop, courtesy of the Fed’s asset-purchase program and liquidity-provision measures. This less-attractive opportunity set for bond-basis trading is offset by a more attractive opportunity set for other trading activities, such as strategies to trade around auctions, asset swap spreads and yield curve trading. However, for many managers, these strategies present neither a scalable risk allocation, nor the same ability for leverage. Beyond this, they do not provide the consistent opportunity set or catalyst that bond-basis trading does. Thus, they can complement P&L, but will not be able to drive above-average returns. The same applies to other non-traditional fixed-income relative value strategies, such as discretionary macro, volatility, mortgage and cross-asset volatility trading. In these strategies, opportunities are attractive, but usually cannot be the dominant driver of P&L given their risk allocations. In this context, manager selection will be important.

The risks to this scenario are biased to the upside, rather than the downside. This is because we believe that there could be episodes of interest-rate volatility this year due mainly to three factors:

• High uncertainty surrounding speed of Covid-19 vaccine deployment and its impact on economic growth and inflation in 2021
• A high amount of positive net issuance of U.S. Treasuries
• Uncertainties regarding President Biden’s fiscal stimulus plan

As in 2020, these macro uncertainties pose the risk of negative P&L in the short-term, but the potential for higher potential return generation once the dislocation calms down. There are also reasons to hope that the opportunity set for bond-basis trading in Europe may improve, including:

• Probable positive net new issuance of Bunds at certain points during the year
• Slow Covid-19 vaccine roll-out
• Political uncertainty in Italy

There may be good opportunities to trade tactically around auctions in Europe, as well as trading peripheral sovereign bonds versus core bonds.

Fixed-income – asset backed
Forward-looking rating: Neutral

As we enter 2021, the macro and policy backdrop for structured credit and related specialty finance strategies continues to look highly supportive. The Fed, the European Central Bank (ECB) and other developed-market central banks remain fully committed to ensuring a low-interest-rate environment and strong liquidity conditions. On top of this, governments have engaged in ample use of fiscal policy to ensure support for the real economy and may continue to do so. This said, with spread levels having round-tripped back to pre-Covid levels, many of the opportunities to invest in-low hanging fruit and obvious mispricing from March/April are now gone. For investors looking for yield, we believe that current market conditions calls for careful security selection, and patience around entry points.

Fundamentals are stronger in some areas of asset-backed strategies and more mixed in others. Consensus is that residential mortgage-related investments are highly attractive, supported by robust housing and consumer fundamentals. Specialty strategies targeting lot development and land banking have also reported strong technicals coming into 2021, with housing supply reduced to weeks instead of months. In the agency MBS space, there remains good opportunity to acquire attractive carry, as well as to trade relative value across coupons and related mortgage REIT equities.

We also see good opportunity to invest in areas of structured credit, including CRE and CMBS related sectors. While agency CMBS and other securitizations backed by multi-family residences continue to perform solidly with good credit metrics, there are increasingly targeted opportunities to invest in distressed or dislocated CRE.

CMBS tend to be backed by properties that have come under significant pressure due to Covid-19 and the sharp change in demand for physical space. These segments include retail, hotels and offices in gateway cities, for example. As further evidence of decreased rent receipts and other financial data roll in, against heightened pre-Covid valuations, it is expected that some sponsors or operators may need to adjust the capital structure backing their properties or restructure their portfolios. We are excited about the opportunity set here and believe 2021 could provide a good entry point.

In other specialty finance segments, the outlook for transport-related strategies remains bifurcated. On one hand, cargo aviation has entered a period of strong demand, fueled by a significant reduction in passenger travel and thus cargo-carrying aircraft. On the other, passenger aviation remains a highly challenged business due to travel restrictions as the virus persists and, in some cases, mutates.

Fixed income – corporate
Forward-looking rating: Positive

Our outlook on fixed income – corporate remains positive. We see robust opportunity in the recovery phase of the cycle, with long opportunities to buy performing bonds and loans in heavily Covid-affected, and in some cases ESG-impacted, sectors, while shorting the equity with derivatives. Issuance and trading volumes remain robust, with leveraged-loan funds now seeing inflows for the first time since 2018. Following record bond issuance in 2020, we think managers that can sort through the layering across the capital stack may be poised to outperform. Second-lien loans may offer higher yields and opportunity, yet recovery values for subordinated bonds have reached historic lows and are expected to remain poor. Across the derivatives landscape, we also see attractive trading opportunities in high-yield mezzanine and investment-grade equity tranches. Finally, we are excited about the opportunities emerging in systematic credit strategies, which are benefiting from high levels of dispersion and volatility in the credit markets.

Fixed income – convertible arbitrage
Forward-looking rating: Positive

We continue to hold a positive outlook on the opportunities for convertible-arbitrage managers, as many of the same trends that drove strong returns in 2020 remain in place. The key elements supporting our positive view on the strategy are a robust new issue market, high levels of market volatility and a highly accommodative monetary and fiscal policy backdrop. While new issuance levels for 2021 will not reach the record-breaking pace of 2020, the breadth of expected issuers is likely to increase sector diversification at the index level, while still maintaining a historically above-average pace of issuance. We continue to expect heightened levels of volatility in markets, presenting further gamma trading opportunities for managers. These heightened levels of volatility also have a derivative effect of making convertible bond issuance more attractive for corporations, as do record level equity prices.

While a more robust rebound may reduce some of these measures, accommodative monetary and fiscal stances will likely remain in place to support the underlying economy. This supports tighter credit spreads and higher convertible bond prices. Lastly, we also see a positive opportunity set for the non-core sub-strategies, such as capital structure arbitrage, event-driven positions and SPACs, where managers with an expertise in credit underwriting and derivative modelling may be able to extract additional returns.

Volatility
Forward-looking rating: Positive

Our outlook for volatility remains Positive. Within this space, we remain bullish on strategies with a relative value bias that have a neutral outlook for tail-risk strategies. We continue to anticipate high levels of global economic dispersion, which could provide a profit source across regions and asset classes for managers. Regardless of the path for volatility, relative value managers may be well-positioned to take advantage of this due to their agnostic approach to the direction of volatility and ability to express trades around the VIX term structure.

For tail-risk managers the outlook is weaker, with managers noting that volatility is expensive and convexity payoffs are more muted. However, we remain neutral on tail-risk strategies, noting that there are several factors that could cause volatility to rise further. These include virus mutations, vaccine bottlenecks, the rising impact of retail investors and overstretched equity-market valuations. 2020 was the worst year for S&P 500 Index futures’ liquidity since 2007. This does not necessarily lead to persistently high volatility, but could cause more frequent and severe market shocks.

On the other hand, with the U.S. election and the risk of a no-deal Brexit behind us and the potential for further unprecedented monetary policy ahead, the overall direction of assets may still be higher. We expect strategies including dispersion to provide strong opportunities on the back of diverging performance across regions and equity market sector rotations. Additionally, there are discussions around a resumption in interest in short volatility strategies, as investors search for yield.

Forward-looking ratings summary

IMPORTANT INFORMATION

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Past performance is not an indication of future results.

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

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