Hedge Fund Strategies Well-Positioned for the Uncertainty of 2021

Brooks Ritchey and Robert Christian on hedge-fund strategy opportunities.

    Brooks Ritchey

    Brooks Ritchey Senior Managing Director, Co-Head of Investment, Research & Management, K2 Advisors

    Robert Christian

    Robert Christian Senior Managing Director, Co-Head of Investment, Research & Management, K2 Advisors

    "Given the lingering uncertainty surrounding the COVID-19 health crisis, the development of a vaccine, geopolitical events and governments’ policy response, we favor nimble, shorter-term strategies. It is prudent in our minds to remain somewhat conservative, but to seek opportunities within alternative investments with low correlation to broader risk assets."

    Wide fundamental variances in valuations and growth prospects for various asset classes, geographies and sectors, often accelerated by the pandemic’s impact, defined the opportunity set for hedge fund-based strategies in 2020. Looking ahead to 2021, that divergence could well narrow, driven by catalysts such as reflation efforts, a weakening US dollar and the possibility of widespread changes in regulatory policies.

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    We see increasing signs of a potentially sustainable rotation in the coming months, in which managers buy or add to sectors and markets that have lagged in recent years (and through the pandemic), while taking profits or applying hedges where they believe the good news has been priced into valuations. Staying on top of those rotations will likely be the key to strong performance potential. Nimble managers may look to a recovery for energy and raw materials, such as base metals that could benefit from Chinese growth. Others may de-risk in the United States and add to emerging markets. The ultimate driver could be one or more vaccines—which could be a game-changer, even if they are not adopted or available right away—or some other clear sign that global growth is recovering.

    Finding Opportunities amid Uncertainty

    Over the next 12 months, we believe three hedged sub-strategies are likely to perform well and improve their risk/reward ratio.

    Discretionary macro managers are well-positioned, in our view, because macroeconomic events are likely to remain a leading market driver. Developments surrounding the health crisis, geopolitical negotiations and fiscal policy spending decisions around COVID-19 stimulus and inflation policy will likely continue to create market fluctuations and opportunities.

    Long/short equity strategies may benefit from their ability to capitalize on both improving and weakening trends driven by the dispersion and volatility of pandemic-related disruptions and events. We also believe long/short credit managers could take advantage of the potential for an increase in company bankruptcies and bond defaults. We saw this during the March 2020 selloff, and while unprecedented stimulus efforts from global central banks have kept interest rates low and helped maintain liquidity, we are concerned that their effectiveness may wane in 2021.

    One of the core themes behind this thinking is reflation. The US Federal Reserve’s shift toward flexible average inflation targeting represents the central bank’s latest effort to drive stubbornly low inflation higher. That commitment, echoed by other central banks, may work in conjunction with potential increases in fiscal spending for infrastructure, vaccine news and renewed economic growth to lift expectations for future inflation, prompting a steepening yield curve and a weakening US dollar. Besides reflation, we are monitoring regulatory and tax policy shifts that could cap the rally in technology and health care stocks. We are also looking toward hedged strategies with a focus on recovery in Asia and emerging markets.

    Looking Ahead, Post-Election

    While the US elections are largely in the rearview mirror, it is still early to clearly envision the policy impact of the new administration, in terms of potentially higher taxes, shifting health care benefits, or regulating fossil fuel producers and technology giants. That said, President-elect Joe Biden’s views on traditional energy, information technology and health care costs indicate that these sectors may lag the broader market going forward. Conversely, industries within clean energy, industrials and materials may perform well on a relative basis. It will be important, in our view, to monitor the scope of infrastructure stimulus in 2021 and beyond. We will also pay close attention to any developments surrounding potentially higher corporate and personal income taxes, which could weigh on the growth outlook for consumerfocused companies.

    Why Hedged Strategies Now?

    Going back to 2000—a period covering the dot-com bubble, the global financial crisis and the longest-ever US bull market— hedged strategies have clearly displayed their ability to provide diversification benefits alongside stock and bond holdings. Comparing the annual returns of stocks (based on the MSCI World Index), bonds (Bloomberg Barclays Global Aggregate Index) and hedge funds (HFRI Fund Weighted Composite Index) over 20 years, bonds led 43% of the time and stocks 38%.1 Hedge funds topped the rankings just 19% of the time, but they never finished last.2 Hedged strategies tend to offer a low correlation with equities with a lower level of risk, historical outperformance when bonds decline, and a level of volatility similar to US Treasury bonds. (Past performance is not an indicator or a guarantee of future performance.)

    In today’s environment, that kind of diversification could be especially valuable. As markets toggle between “risk on” and “risk off” sentiment, investors looking to reduce their exposure to either equities or bonds without moving into cash may find hedged strategies a beneficial complement to traditional, longfocused positioning.

    ENDNOTES

    1. Source: MSCI, Bloomberg Barclays, Hedge Fund Research, Inc. (www.hedgefundresearch.com). Data from 1/1/00 through 9/30/20. Indexes are unmanaged and one cannot invest in an index. They do not include fees, expenses or sales charges. The HFRI Fund Weighted Composite Index is used under license from Hedge Fund Research, Inc., which does not endorse or approve of any of the contents of this report. Past performance is not an indicator or a guarantee of future performance. Important data provider notices and terms available at www.franklintempletondatasources.com.

    2. Ibid.

    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. The identification of attractive investment opportunities is difficult and involves a significant degree of uncertainty and there is no assurance any such alternative investment strategies will be successful. An investment in these strategies is subject to various risks, such as those market risks common to entities investing in all types of securities, including market volatility. It is always possible that any trade could generate a loss if the manager’s expectations do not come to pass. The market values of securities will go up or down, sometimes rapidly or unpredictably. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Hedge strategy outlooks are determined relative to other hedge strategies and do not represent an opinion regarding absolute expected future performance or risk. Conviction sentiment determined by the K2 Research Group is based on a variety of factors and may change from time to time. Diversification does not guarantee profit or protect against risk of loss.