Hedge Fund Strategy Outlook

Q3 2018

To begin each quarter, the Research and Portfolio Construction teams at Franklin Templeton’s K2 Advisors share their outlook for hedge strategies. We believe offering these insights to investors and financial advisors will help them better understand the rationale for owning retail mutual funds that invest in hedge strategies.

You're Still Gonna Need a Bigger Boat…

Perhaps one of the most popular K2 Perspective's we've ever written was the June 2014 issue, where we referenced Roy Scheider's memorable line from the 1975 summer blockbuster Jaws. We thought now, especially given the current state of the markets, would be a good time to revisit the subject.

For us the infamous Jaws line (a brilliant ad lib, by the way) allegorically brings to mind our current situation. While risk assets continue to rally, investors – much like their beleaguered counterparts from the fictional island of Amity – remain cautious, and indeed may be looking for a bigger, or at the very least a better, boat. Perhaps they seek a craft more sturdily constructed to withstand the potential macro risks circling just under the deceptively calm market waters – we know we certainly would.

While things remain relatively tranquil on the surface, macroeconomic concerns – including geopolitical hot spots, growing political uncertainty in Europe, trade wars and major central bank policy divergence – all pose legitimate problems for market stability. In addition, perhaps one the most overlooked concerns today is the threat of continued rising interest rates in the United States…cue the John Williams score. A persistent and potentially dramatic spike in interest rates could represent a metaphorical Great White macro risk for portfolios not well positioned.

Indeed, if rising interest rates eventually do bite, some investors may start to feel the downward drag. Fortunately the story does not have to end there, and portfolios are not doomed to the fate of the USS Indianapolis. In our view, there does exist a better boat, one constructed not only of equity beta and bond beta, but one built around alpha also. We believe this alpha boat may fare quite well in a rising rate environment, perhaps even prospering…and living long as well (to mix our movie metaphors).

In our view if interest rates spike, bonds will naturally suffer some, equities will probably do okay, but the real strength will be in alpha-generating strategies like hedge funds. Statistical analysis of the historical relationship between Treasury yields and alpha support this. In Exhibit A we have created a Factor Response Curve that illustrates the historic relationship between HFRI Fund Weighted Composite Index alpha levels and US 5-year Treasury yield levels.

Exhibit A

HFRI Fund Weighted Composite Index Alpha at Different 5-Year U.S Treasury Yield Levels
(January 31, 1991 - May 31, 2018)

Average yield quintiles

Quintile avg. annualized 12-mo. forward-looking Alpha

For illustrative and discussion purposes only.
Source: Bloomberg, HFR, and S&P Dow Jones Indices. January 1991 through May 2018. Important data provider notices and terms available at www.franklintempletondatasources.com. Alpha calculated relative to the S&P 500 Index. Alpha is a mathematical value indicating an investment's excess return relative to a benchmark. Measures a manager's value-added relative to a passive strategy, independent of the market movement. The Factor Response Curves show the average performance of the index during the review period in months when the factor falls into the performance quintiles indicated. The blue bars indicate the average performance of the factor over all months when the average performance of the factor falls within the given quintile. The green dots represent Hedge Strategy Alpha (Forward Looking - 12 Month) vs. S&P 500, are measured through May 31, 2018, and are solely based on historical data. Each underlying yield data point has a corresponding hedge fund alpha vs. the S&P 500, where alpha is measured over the subsequent 12 months from the point where the yield is measured (most recent yield measurement in illustration is as of May 31, 2017). Past performance is not an indicator or guarantee of future results. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Unlike most asset class indexes, HFR Index returns reflect fees and expenses. Source for HFR: Hedge Fund Research, Inc. - www.hedgefundresearch.com. The HFR indices are being used under license from Hedge Fund Research, Inc., which does not endorse or approve of any of the contents on this report.

As you can see, when interest rate level averages have been at their lowest, represented by the first quintile bar on the left, average alpha levels have also been at their lowest. But as we move from lower yield levels to higher average levels across the five quintiles, we see a corresponding rise in average alpha as well.

While we know that past performance doesn't guarantee future results, higher nominal yields of US government bonds, such as five-year Treasuries, have on average historically corresponded with increased average annualized hedge fund alpha capture as well. In our experience, the vast majority of hedge funds are defensive with respect to interest rate risk, while some macro managers see it as a speculative opportunity. The implication of sharply rising rates for individual and institutional portfolios, particularly for fixed-income investments, could be troublesome as they may be confronted with diminishing returns or potentially significant losses – depending upon duration risk and the magnitude and velocity of any rate rise.

We believe an alpha boat is the best option available to hedge against the eventual attack.

Event Driven

Corporate activity has been strong in 2018, and we believe it will remain that way due to high levels of CEO optimism, tax cuts, and cash repatriation. Merger arbitrage spreads remain attractive relative to Treasury yields while special situations and activism will be more equity market dependent.

Global M&A Activity (January - April)

Source: Bloomberg as of 5/1/18. Global merger and acquisition (M&A) transactions over $500mm from January to April. Past performance is not an indicator or guarantee of future results.

Discretionary Macro

Our theme of diverging central bank policies across major developed and developing markets remains intact, and combined with a busy global political calendar, we believe these actions to be a source of potentially significant market volatility - particularly across rates and currency markets (areas where macro managers traditionally participate actively). The outlook for Emerging Markets in particular is somewhat cautious as we believe those markets to be particularly susceptible to foreign capital flows (often in response to recent performance). This weakness is likely to eventually present an attractive buying opportunity, but we are not yet ready to call the bottom of the EM cycle. However, we obtain much of our EM exposure through managers who are either highly defensive or actively trading. We feel both approaches are favored in the current environment over the alternative of being significantly net long.

Long Short Equity

We maintain a positive outlook for long/short equity managers - particularly those with global perspectives. While U.S. equities continue to benefit from a strong economic tailwind, long/short equity managers are also benefiting from a pickup in equity volatility and dispersion given the unpredictable macro backdrop, recurring headlines of trade wars, and the upcoming mid-term elections. We expect managers to continue to generate alpha in both their long and short books as a result.

12-Month Rolling Volatility
December 31, 2017 - June 26, 2018

Source: Morningstar Direct, MSCI, and S&P. Important data provider notices and terms available at www.franklintempletondatasources.com. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Indexes are unmanaged and one cannot invest directly in them. They do not reflect any fees, expenses, or sales charges. Past performance is not an indicator or guarantee of future results.

12-MONTH OUTLOOK SUMMARY FOR Q3 2018

  • Neutral
  • Up Trend
  • Down Trend
StrategyConviction SentimentSummary Statement
Long/Short Equity

We maintain a positive outlook for long/short equity managers – particularly those with global perspectives. While U.S. equities continue to benefit from a strong economic tailwind, long/short equity managers are also benefiting from a pickup in equity volatility and dispersion given the unpredictable macro backdrop, recurring headlines of trade wars, and the upcoming mid-term elections. We expect managers to continue to generate alpha in both their long and short books as a result.
Relative Value

The less directional nature of relative value strategies remains attractive amidst the greater uncertainty in the markets. We maintain a slightly positive view for convertible arbitrage and a neutral outlook for fixed income arbitrage and upgrade our outlook for volatility arbitrage due to the strategy’s favorable reactivity to potential external risk events.
Event Driven

Corporate activity has been strong in 2018, and we believe it will remain that way due to high levels of CEO optimism, tax cuts, and cash repatriation. Merger arbitrage spreads remain attractive to us relative to Treasury yields while special situations and activism should be more equity market dependent.
Credit

Interest rates are starting to rise, and duration risk is still prevalent in the credit markets. Long/short credit managers have naturally shorter duration portfolios and should benefit from increased sector dispersion. Defaults remain low with limited new opportunities. In structured credit, fundamentals remain strong and yields look attractive on a relative basis. In private credit, we prefer niche strategies.
Global Macro

We have our most favorable outlook for discretionary macro managers, a somewhat more cautious outlook for emerging markets, and a neutral view on systematic strategies. We believe weakness in EM may persist for the near future, though possibly present attractive buying opportunities later in the year. Systematic strategies remain at risk of getting whipsawed by choppy market action.

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