05 March, 2021


“..a phoenix is a long-lived bird that cyclically regenerates or is otherwise born again. …a phoenix obtains new life by arising from the ashes of its predecessor.” Wikipedia.

 

The mythology of the phoenix holds different meanings for many but at its core is a story of a difficult period, followed by regeneration and recovery. 2020 was a good year for hedge funds. The HFRI fund-weighted composite returned +11.6% net of fees, making it one of the best years for performance and alpha in a decade.1 In the wake of many challenging years for hedge funds, 2020 marked something of a change. The low volatility and low dispersion regime that had stifled prior periods cracked definitively during the COVID-19 pandemic to unleash wholescale uncertainty across the globe. This brought with it both risk and opportunity in financial markets. Hedge funds by design seek access to a wide range of both risk and return levers and they brought this flexibility to bear as 2020 unfolded. Their performance, viewed at a high composite index level or across underlying sub-strategies, shows a broad positive picture, net of fees.

 

Absolute performance is only part of the story: these returns were achieved with significantly less risk, illustrated by a standard deviation which was much lower than equity markets (about half on average). This highlights their ability to dampen drawdowns against a backdrop of much larger market losses.

Figure 1. Performance of the HFRI versus MSCI World Index over 2020

 

 

 

Source: MercerInsight®. The HFRI Institutional Fund-Weighted Composite Index is a global, equal-weighted index of hedge funds with minimum assets under management of US$500m which report to the HFR database and are open to new investments. The index constituents are classified into equity hedge, event driven, macro or relative value strategies. The index is rebalanced on an annual basis. Returns are net of fees and in US dollars; MSCI performance is gross.


It is also worth highlighting how hedge funds generated this performance. Exposure across the main HFR hedge-fund categories to traditional risk (such as the equity market) remained low to modest, as shown in Figure 2. 

Figure 2. Rolling one-year betas versus the MSCI World Index. Five years to December 31, 2020

 

Source: MercerInsight®. March 2020 remains an outlier data point (due to speed and extremity of market moves) so be aware that it may create some short-term distortion to these metrics. However, it is natural to see a spike in beta profiles across asset classes as market participants react to fear in the depths of a crisis.


Analysis indicates that managers were not relying on traditional equity beta alone for performance and were instead able to deliver diverse and more unique sources of profit. The changing tone of markets has opened up more scope for those prepared to leave the well-beaten path of traditional beta. It highlights a richer environment for idiosyncratic or alpha returns.

Under the bonnet

The headline summary masks big differences in performance between managers. Even at a composite level, hedge fund indices can obscure wide spreads in the distribution of returns, as shown in Figure 3.

Figure 3. Difference in annual hedge fund returns between the 5th and the 95th percentile


Source: MercerInsight®. HFRI


This spread in performance highlights the importance of manager selection. Even within similar strategy groups, investment approaches can diverge significantly in style, investment horizon and focus. In 2020, these differences mattered all the more in such a dynamic market environment. Investor experience in the year and their outcomes may have varied significantly depending on their selection of managers, blend of styles (for example, exposure to discretionary vs quantitative) and any constraints around their portfolio implementation.

As reported by HFR and Societe Generale, all the main hedge-fund categories ended 2020 positive, as shown in Figure 4.

Figure 4. Performance of hedge funds in 2020

 

Index name

2020 (%)

HFRI Equity Hedge (Total)

17.7

HFRI Event Driven (Total)

8.9

HFRI Macro (Total)

5.5

HFRI Relative Value (Total)

3.4

SG CTA Index

3.2

HFRI Fund Weighted Hedge Fund

11.7

MSCI World

16.5

Source: HFR & SG


The strongest performance came from equity strategies, who saw fertile conditions for stock-picking. Alpha came from both longs and shorts with some managers posting positive attribution from both sides as the pandemic seemed to both accelerate structural challenges facing companies as well as introducing new risks, creating winners and losers. Importantly, gains across the managers we track were not isolated to large-cap technology or work-from-home themes, but rather across a wide swathe of market cap, industries and regions. This was also observed in corporate credit where an ambidextrous approach (both long and short) in investment grade and high yield markets was rewarded over the year.

 

Event-driven strategies also saw a strong year. The pandemic’s impact in the first half of the year gave way to a rebound in activity that provided funds with a broad range of opportunity, as the crisis served to accelerate the need for strategic corporate decisions. The picture in relative-value approaches, while positive, was more mixed. This investment style typically relies more on leverage, and lending came under pressure, particularly in the eye of the storm in March 2020. This created financing or funding stress, leading to significant price volatility. However, many of these strategies recovered well, to end the year positive.

 

Macro managers found a similar strong opportunity set in the wake of global regulatory and political responses to the pandemic. Fixed income, commodities and currency markets were profitable areas of risk-taking over the year, with managers taking both outright views and relative-value views (for example, preferring the recovery prospects of one nation compared to another). Global interest-rate markets were particularly profitable for managers, and inflation risks injected additional opportunity. Some of these outright price moves were also captured by trend followers, who also ended 2020 positive. However, there were clear differences in these systematic approaches across time horizons (short or longer speeds) as well as asset class bias (and target volatility levels) that created a wide spread of results.

 

In style terms, there was notable outperformance of discretionary over quantitative approaches, particularly those reliant on fundamental information rather than technical patterns (such as trends). This outperformance was especially pronounced in equity, global macro and risk premia strategies. Unlike discretionary managers, who were able to adapt and pivot quickly, quantitative managers were hostage to rules based on fundamental data sets that had not seen a global pandemic. Factors and risk premia exhibited much higher levels of volatility, particularly around the more generic areas of value and momentum, leading to losses. Regime change and turning points have always been weaker spots for these styles, which require time to catch up on shifts in fundamentals: 2020 proved a painful reminder of this. We are shortly publishing a paper to discuss this issue in more detail, in particular for alternative risk premia strategies. 

 

All these divergent paths to a broadly positive year for hedge-fund strategies serve as a reminder of how heterogeneous the hedge-fund universe is, indicating the challenges and complexities inherent in selecting and blending hedge fund strategies. These areas require greater focus and we will explore them in more detail in future work over the coming year.

 

Phoenix moment or one-off event?


So was this really a “phoenix” moment or just one good year? Has the publicity in the wake of the recent GameStop short squeeze2 and short-selling dented this moment? No. In our view, the outlook for hedge funds remains very positive and arguably the strongest for a decade. Market evolutions and investor behavior have always created both challenge but also opportunity.

 

The political, economic and social repercussions of the pandemic continue to fuel an uncertain and volatile trading environment. This will likely benefit those strategies which can be agile and opportunistic. The increasingly different paths pursued by nations are creating meaningful macro opportunities across different countries and asset classes. Companies facing an uncertain future continue to bring dispersion to corporate credit and equity markets. A long and short approach to investing remains well placed to continue finding such winners and losers. Events like the GameStop short squeeze serve as important reminders of risk discipline, while hedge funds have long demonstrated an ability to regenerate and adapt to new challenges or threats, across multiple regimes. Outside of pandemic impacts, we are also witnessing a change in investor preferences in areas such as responsible investment. Hedge funds are responding with innovative and interesting ideas to these shifts, though it remains early days. We look forward to highlighting more on this topic later in the year.

 

These unpredictable markets call for a rare balance between discipline and dexterity, with versatility vital to enduring success. This coincides with a time when traditional asset classes appear challenged: either in frothy equity valuations or limited upside for bonds, with the shadow of inflation stalking both. Diversification may also prove harder to find. In a world where cash offers little return and the topic of asset bubbles occurs with frequency, options for investors are becoming more limited. In our view, this points to a valuable role that hedge funds can play in bringing different sources of return, now and looking ahead.





Author

Penny Aitken (ACA)
Penny Aitken (ACA)
European Leader of Diversifying Alternatives Research
penny.aitken@mercer.com


[1] Prior peak for the HFRI fund-weighted composite was in 2009 at +20%.

[2] See our recent paper at https://src.mercer.com/news/601789ce2d45a100246a8691/Mercer_Social_Media_to_Social_Markets_Viral_Trading_and_Short_Squeezes.

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