We do not remember a market environment with as wide an array of potential outcomes as we are witnessing right now. Certainly, inflation is the topic that garners the most attention, given its impact on the forward path of interest rates, the strength of the consumer, global currencies and overall spending power. Unfortunately, inflation is not the only overhang that is troubling global investors. Increasing geo-political instability, led by the ongoing Russia / Ukraine conflict, combined with slowing global economic growth, a tightening capital market backdrop, de-globalization, concerns around big-tech, a still-lingering global pandemic and a confusing U.S. political outlook are just a few of the additional questions plaguing the market. These risks arose fairly quickly following a sustained period of fairly tranquil markets over the past decade. Interest rates were low, inflation was low, geo-political risk was (relatively) calm and capital markets were wide open.

Given this pivot, investors are grappling with the question of where to turn to for returns. We view alternative strategies, hedge funds specifically, as uniquely and particularly well-suited options from both a return and diversification perspective. That said, not all hedge fund strategies are created equally and not all hedge funds deliver the same underlying risk and return characteristics. For example, macro-oriented strategies, as measured by the HFRI 500 Macro Index, were up c14.3% in 2022, while equity-oriented strategies, as measured by the HFRI 500 Equity Hedge Index were down c12.6%.

In this update, we summarize some of the key drivers supporting our favorable outlook for the asset class and elaborate on the opportunity within sub-strategies.

Macro

Discretionary thematic

Forward-looking rating: Positive

The opportunity set for discretionary macro managers continues to be broad, yet most themes and views, at least in the near term, will still be driven by inflation prints and interest rate policies. Macro managers are much closer in their thinking about the terminal Fed funds rate, however differences around the length of the tighter policy and a potential policy reversal remain. We believe that directional and relative value opportunities in interest rates will reward a number of more experienced managers, used to different rates policies and inflation regimes. Currency trading is expected to be wide-ranging and thus more challenging with the US dollar likely to have already peaked in the current cycle.

Regionally, we are cautiously optimistic on the opportunity set for emerging market-focused managers, an area where a number of names experienced significant drawdowns in 2022. We also expect that the zero covid policy easing in China will create opportunities for regional specialists, especially for those who can take advantage of credit investments. Commodity-focused managers are less likely to sustain the pace of very strong returns in 2023, though we still see energies trading as attractive in the near term. Although discretionary thematic performance dispersion is historically wider than most strategies, 2022 was abnormal in that there were funds that generated triple-digit returns and others that incurred large double-digit losses. We think this should slightly compress in 2023, and at the very least we would expect the group average to be above what was realized in 2022.

Systematic diversified

Forward-looking rating: Neutral

Following historically strong returns in 2022, a function of which was combination of a major regime shift and investors building and keeping excess cash, we expect systematic strategies to revert to return levels more in line with historical averages. Although the possibility for market shocks remains high given the geopolitical and economic backdrop, most of these “unknowns” are known to investors; in fact, we believe that investors have largely prepared their portfolios for most of these shocks. This should bring about more market stability, which could be positive for trends (and therefore systematic managers), but it could mean that investors are too defensively positioned if a “soft landing” is achieved leading to a large and quick risk-on rally.

To this point, inflation data in the US has started to gradually trend lower which has led to declining expectations for further Fed rate hikes, hurting current systematic biases. Any quick and temporary sentiment shifts will weigh heavily on systematic managers performance, weakening the signal strength and resulting in loss-driven de-grossing. Cognizant of these risks, we still see opportunities for systematic managers going forward. We believe that a more gradual risk build-up, supported by increasingly dovish central banks, only a mild recession and geopolitical de-escalation, could create a good backdrop for systematic managers. We continue to observe that conviction in fixed income, which historically has been a large driver of systematic returns, still remains relatively low, with managers currently expressing only either moderate long or short exposure. We expect this to be an area where managers allocate more, as other asset classes start to screen as less attractive or their positioning is already at limits.

Equity hedge

Forward-looking rating: Neutral

Equity beta is a material component of Equity Hedge returns and calling the direction of equities from here remains a precarious task. What we can say with some confidence is that beta will not be the tailwind to performance that it was over the extended period of extraordinarily loose financial conditions since the GFC. The performance of equities, and equity market leadership, from here will be dependent on the path for global growth, inflation, interest rates and resultant central bank policy, as well as a myriad of exogenous issues, including geopolitical conflict, deglobalization and a shifting energy landscape. In the short term, equity markets could continue to be characterized by repeat bear market bounces followed by fresh pullbacks, in the absence of a sustainable new bull market taking hold. In such an environment, directional Equity Hedge managers are, in aggregate, likely to underperform more hedged peers, though with brief periods of respite and outperformance as intermittent sharp market rallies and rotations favor those with smaller short books.

While the outlook for beta is uncertain at best, the bottom-up stock picking (alpha) opportunity set is looking attractive. We are entering a new market regime that will likely be characterized by lower liquidity, lower equity returns, higher rates, higher volatility and greater return dispersion. Higher volatility means mispricing, which in turn means opportunities on both sides of the book. We believe that these combine to create the backdrop for tremendous alpha opportunities, long and short, as the market becomes more discerning and distinguishes winners from losers. We expect intra-market correlations to fall from elevated levels accordingly, marking an improved environment for stock pickers. Alpha should become a more important component of Equity Hedge returns in this new regime, taking the baton from market beta.

That said, we believe this regime transition will continue to present obstacles to alpha-focused strategies over shorter-term periods. Sharp bear market bounces can be a source of significant underperformance for funds with large short books as forced widespread short covering can trigger industry-wide de-grossing. This can have a meaningful impact on alpha generation and performance over shorter periods of time. Appropriate portfolio construction and robust risk management are critical differentiators in such scenarios.

Overall, we expect that relative performance between fundamental growth vs fundamental value to become a more nuanced dynamic going forward. We seek to maintain balance across both as managers of different style dispositions find compelling stock-specific opportunities across the spectrum. We think the quality factor becomes a more important consideration in the prevailing environment. Quality can straddle both value and growth and we think that quality long/short considered through a disciplined valuation lens could outperform in a market still highly valuation sensitive and facing a deteriorating earnings outlook.

On balance, the combination of a murky outlook for market beta, a positive outlook for stock picking alpha and the potential for a higher idiosyncratic risk environment sets Equity Market Neutral as a relatively attractive proposition within Equity Hedge. We particularly favor those market neutral/low net managers which seek to limit factor exposure in the book, minimizing systematic risk and maximizing idiosyncratic risk, as such managers will be best placed to exploit the strong ‘pure alpha’ opportunity, often using leverage to enhance risk-adjusted returns.

Event driven

Activist

Forward-looking rating: Neutral

Our neutral outlook has two components. On one hand, we do not expect the inherent beta tailwind component of the Activist strategy to be as prominent. For this reason, and the potential associated trading illiquidity of an activist position, we prefer Activist managers that apply some hedging and are not 100% exposed to equity markets. On the other hand, there is an attractive set up forming for idiosyncratic return opportunities.

Market volatility in 2022 drove an uptick in activist campaigns, with Activist managers on the hunt for on-sale opportunities. With the change in proxy-voting rules, the universal proxy card will likely support this level of new activity, especially with proxy voting season ahead in Q2 2023. Uncooperative management teams might come under threat. The long-term impact of this change is still open to question but could lead to more changes in board rooms. Core, brand-name activists still enjoy day-one stock price appreciation from announced stakes, but a successful campaign that leads to value creation is longer duration.

Special situations

Forward-looking rating: Neutral

Like the Activist strategy, the Special Situations strategy has a large beta component in its returns, which we do not expect to be a tailwind looking ahead. We also temper our outlook because Special Situation managers often target situations with softer catalyst that have a lower probability of occurring. The strategy performs best in bull markets or turnaround phases of a market cycle, neither of which look to be on the horizon in 2023.

The trend we saw last year of managers adding private exposure in late-stage growth companies to capture a hot IPO market has also dissipated. The IPO market has dried up and high-growth companies hurt performance in 2022. As the market resets to focus on improving bottom-line fundamentals, Special Situations managers will look for value realization from different parts of the capital structure around restructurings, spin-offs, acquisitions or even bankruptcies. We have already seen the incremental dollar invested more in credit than equity positions for opportunistic managers.

Merger arbitrage

Forward-looking rating: Positive

We expect Merger arbitrage to continue to deliver strong risk-adjusted returns relative to the other Event Driven sub-strategies. The complex regulatory, macro and geopolitical environments have kept spreads wide. This has also lengthened deal timelines and lowered the probability of completion. But it also created mispricing, and therefore, trading opportunities for Merger Arbitrage managers. Today, it is very much higher interest rates that drives our positive outlook for the strategy. The positive interest rate carry associated with a deal spread outweighs our concerns around re-investment risk given our expectation for lower levels of deal activity in 2023 than we have seen in recent years. Increased deal volumes don't necessarily translate to better returns, but our research does suggest that higher interest rates lead to higher returns for the strategy. We continue to place great importance on individual deal analysis, selection and trading to generate excess returns over passive merger arbitrage strategies.

Distressed

Forward-looking rating: Neutral

We upgraded the outlook from negative for classic default and restructuring opportunities. US defaults in 2022 remained below the long-term average although there has been a notable increase from the historically low level in 2021. We continue to expect environment in 2023 to remain relatively low despite the increase in rates partly because of the maturity schedule. There is a relatively low percentage of the outstanding leveraged credit market that will need to refinance before the end of 2023. The key is that if policy rates do remain above 4.0% for another 18+ months and earnings growth remains muted, it could create a slow cascade of defaults in late 2023/early 2024. In this instance, the worry would be about the “length” of the default cycle rather than its "height.”

Multi-Strategy

Forward-looking rating: Neutral

An allocation to the strategy can serve as a core holding in a portfolio because managers (a) focus on capital preservation and (b) have the flexibility to shift exposure between asset classes and strategies depending on the opportunity set quicker than we can. However, the underlying ratings of each sub-strategy drives our decision to downgrade the strategy. Three have a neutral rating (Activist, Special Situations and Distressed) and only one has a positive rating (Merger Arbitrage).

Relative value

Fixed income - Sovereign

Forward-looking rating: Positive

2022 marked the return of notable volatility across fixed income instruments in developed markets, with G7 central banks having notably tightened monetary policy, high levels of uncertainty on inflation, as well as on-going geopolitical tensions. Consistent with history, higher levels of interest rates and increased volatility in fixed income assets have translated into an improved opportunity set for relative value managers not only in cash vs. futures basis trading, but in other traditional strategies such as asset swap spreads, yield curve arbitrage, macro, inflation and cross-currency basis trading. Although we believe that fixed income volatility may subside from extreme levels in, we expect it to remain high in 2023. This should allow managers as a group to capture more of the increased opportunity set than they did in 2022, which was a year with dispersed and volatile returns.

Fixed income - Asset-backed

Forward-looking rating: Positive

We are continue to hold a positive outlook despite spread-widening in 2022 because we believe the strategy is well positioned for an inflationary environment due to rising underlying collateral values and cash flows. We have however upgraded the following:

• Residential mortgage-backed securities (RMBS) – We are generally constructive on the structured credit universe. Legacy RMBS spreads widened in 2022 on concerns over a recession in 2023 and falling HPA. However, these mortgages have de-levered significantly over the last two years and the average loan age is now more than 15 years and most refinanced when interest rates were lower. Newer issue RMBS have faced headwinds with significant new supply coming to market in 2022, based on the significant mortgage loan origination over the prior 18 months. This has created a technical overhang which is likely to lead to a future decline in the rate of new primary market supply. As buyers digest the supply over the next 12 months, spreads are likely to tighten.
• Commercial mortgage-backed securities (CMBS) – There should continue to be attractively priced opportunities in areas where property-level due diligence is paramount, for example single-asset single-borrower (SASB) loans. Managers must be discerning when trading CMBS issues, although concerns over defaults are reflected in wider spreads.
• Asset-backed securities (ABS) – The Consumer ABS story is one of negative fundamentals, but one in which prices largely reflect these concerns. While we expect continued weakness in consumer performance next year, spreads in ABS have widened and are now near April 2020 levels in many cases. The story we have been outlining throughout 2022 has been a bifurcation in performance between subprime and prime consumers, which is likely to continue. The macro backdrop will see a continuation in elevated delinquencies and defaults in subprime spaces. However, the relatively strong housing backdrop for homeowners and still positive payroll numbers will keep prime ABS more supported.

Fixed income - Corporate

Forward-looking rating: Positive

We have upgraded our view to positive from neutral on performing credit strategies. 2023 is likely to mark a significant change from the challenging technical environment of 2022 as rising inflation is showing signs of easing, allowing improved stability in rate. Investment-grade yields are at the highest since 2009 and spreads are close to the post-GFC average. Rates stability should also help High Yield total returns, but the starting point for spreads is less appealing. High Yield is likely to be most sensitive to any change in the economic environment, while changes in the Fed policy rate are more likely to impact IG which tends to have more duration. Managers have a compelling opportunity ahead to own high quality credits in companies with pricing power and durable fundamentals. Equally on the short side, there is sufficient differentiation in credits to allow for alpha generation. We remain optimistic on systematic credit strategies which are benefiting from higher levels of dispersion and volatility in credit markets.

Fixed income - Convertible arbitrage

Forward-looking rating: Neutral

There are mixed signals across the convertible bond market, resulting in our net neutral score. By and large, convertible bonds are cheap across all regions for the first time since the Covid crisis, and only the second time since the global financial crisis. Moreover, hedge fund managers in particular see significant opportunities in “busted” convertibles. On the negative side however, the size of the opportunity set has reduced as a result of low issuance in 2022.

Relative value - Volatility

Forward-looking rating: Positive

While we continue to be positive on the outlook for relative value volatility managers, our reasons have shifted. We were previously bullish because volatility across all asset classes was trending higher and the number of idiosyncratic market shocks was rapidly increasing. However now there is less obvious upside to the current levels of implied volatility across most asset classes. The flip side is managers have wider spread opportunities to capture as well as a larger pool of potentially mispriced securities. Additionally, the breadth of plausible outcomes provides another way for the right managers to exploit anomalies and irregularities in the pricing of derivatives. Lastly, we are still expecting elevated levels of equity market dispersion which is more conducive for relative value volatility-focused managers. We do continue to believe that investors should maintain exposure to directional/long-volatility biased strategies as the risk and breadth of shocks is high as is the probability of occurrence, and therefore it seems prudent to own protection.

Important information

Discussion of individual securities above is for informational purposes only and not meant as a buy or sell recommendation nor as an indication of any holdings in our products. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of any mentioned securities.

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.

Hedge funds use sophisticated investment strategies that may increase investment risk in your portfolio. Among the risks presented by hedge fund investments are: the use of unregistered investments, which may make it difficult to assess the performance of the holding; risky investment strategies, which may result in significant losses; illiquid investments that may be subject to restrictions on transferability and resale; and adverse tax consequences.

Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.

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