Hedge Fund Strategy Outlook

Q2 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.


Don’t Fear the Fear Index

We suggested at the end of last year that when the massive tide of global liquidity injected into markets post-2008 begins to recede, a wave of volatility could follow. It appears as though the wave has arrived.

Market volatility — as measured by the VIX (the so-called "fear index") — surged 80% in the first quarter of the year. The S&P 500 and Dow Jones Industrial Average both declined for the quarter respectively, while the Nasdaq Composite Index managed a modest gain based largely on its sharp rise in January. Nine out of 11 S&P 500 sectors traded lower. The steepest declines were in telecommunication services, consumer staples, and energy. Information technology and consumer discretionary were positive outliers despite selling off broadly in March. The negative quarter for the S&P 500 broke a string of nine positive quarters, the longest streak in 20 years. In addition, all of this happened following the nine-year anniversary of the bull market, which began on March 9, 2009, and ten years after the bailout of Bear Stearns.

CBOE Volatility Index ("VIX")
1 Year Ending March 31, 2018

Cyclically Adjusted Price-to-Earnings Ratio

Past performance is not an indicator or a guarantee of future performance. Source: CBOE via FactSet. Data from March 31, 2017 to March 31, 2018. Important data provider notices and terms available at www.franklintempletondatasources.com.

So now what? From our perspective, a reversion from the unprecedented low levels of volatility was to be expected — perhaps even welcomed. In some ways it reflects the resumption of more normalized market behavior. This is a good thing in our view.

As we have said in past letters, the historic levels of quantitative easing following the global financial crisis — that is the expansion of the Fed’s balance sheet from around US$900 billion to nearly US$4.5 trillion today — was one of the most dominant market shaping forces over the last decade. In our view, it caused a distortion in prices, a suppression of volatility, and a reduced emphasis on corporate fundamentals. In addition to yields being driven toward record lows and stock markets to record highs, many investors were pushed toward riskier assets while the cost of capital was kept artificially low. While passive investing thrived in such an environment, it could be argued that active management and hedge funds suffered. As this era of quantitative monetary stimulus slowly winds down, we believe an improved environment for active management will emerge.

Reduced central bank support should make stocks more responsive to idiosyncratic factors. The consensus thought seems to be that less supportive monetary policy will lead to greater price sensitivity from individual company fundamentals, which in turn could lower pair-wise correlations. If this were to occur, we feel this should lead to greater sector dispersion as well, creating a more conducive environment for managers to identify potential winners and losers. As a result, we believe the environment for alpha capture for the remainder of 2018 may remain fertile.


Discretionary Macro

Our outlook for the discretionary macro strategy continues to improve. Increased central bank activism and policy divergence, combined with political uncertainty across major economies, have contributed to an increase in volatility across major asset classes. The increase, while modest, is nevertheless indicative of higher uncertainty and potentially better trading opportunities for managers with flexibility to trade across asset classes (most notably in fixed income and currencies, which have traditionally been a core area of focus for discretionary managers).


Long/Short Equity Europe

The opportunity set in Europe remains favorable for Long Short Equity managers. European equities continue to trade below their historical average valuation versus the US, which we believe to be fully valued. Eurozone forward earnings estimates are trading well below their prior peak, providing ample room for further recovery. US forward earnings, by contrast, are well above their 2008 peak.

MSCI Europe Index 12-month Forward EPS
November 2001 – March 2018

Hedge Fund Long Alpha by Net Exposure

Past performance is not an indicator or a guarantee of future performance.
Source: Thomson Reuters I/B/E/S. Data from November 17, 2001 to March 15, 2018. Time-weighted average of the consensus earnings estimates for MSCI Europe Index for current and next year. Monthly through December 2005, weekly thereafter. 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. Important data provider notices and terms available at www.franklintempletondatasources.com.

European economic growth should continue to improve with low rates, resumption in bank lending, and strong external expansion. We believe the fears of a catastrophe following the Brexit decision are beginning to subside, as the issue appears to be reaching an amicable end for both Europe and the UK. In addition, Europe looks to be positioning itself close to the Trump administration at the trade table, likely putting it in a better position related to China or Japan in terms of any tariff actions by the administration.

Furthermore, the alpha environment appears strong with increased dispersion and decreased correlations impacted by varied regional macro developments, ECB meetings and elections.


Relative Value – Fixed Income

With interest rates finally starting to rise, duration risk is coming into focus for fixed income investors. Relative Value Fixed Income managers such as long/short credit managers appear well positioned, given their shorter duration portfolios, and, in our view, should be able to generate alpha from rising sector dispersion.

High Yield Market Weight by Yield-to-Worst
As of March 21, 2018

Hedge Fund Long Alpha by Net Exposure

Past performance is not an indicator or a guarantee of future performance.
Source: BofA Merrill Lynch. High Yield market represented by the ICE BofAML US High Yield Index. Important data provider notices and terms available at www.franklintempletondatasources.com Indexes are unmanaged and one cannot invest directly in them. They do not reflect any fees, expenses, or sales charges.

The diverging paths of central banks in the major global economies are expected to present improved directional opportunities. Participation from directional buyers and sellers of bonds should result in greater market inefficiencies between cash bonds and futures, benefiting less directional relative value trading. The strategy is still subject to greater leverage and funding risks, justifying a cautious approach.

12-MONTH OUTLOOK SUMMARY FOR Q2 2018

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

Even with our cautious view of the equity markets, we maintain a positive outlook for long/short equity investing grounded in the belief that alpha will likely be a larger driver of returns going forward. The recent pickup in volatility should create opportunities for managers to generate returns on both the long and short sides of their books. With the removal of quantitative easing, we expect earnings dispersion between companies to return. As investors anticipate rising rates and companies incorporate changes from tax reform, sectors and companies should experience reduced correlations and incremental dispersion throughout the year.
Relative Value

In our view, 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. Recent increases in both realized and implied volatility should be supportive of a better trading environment for volatility arbitrageurs.
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. Demand for private credit remains high.
Global Macro

Most favorable outlook for discretionary macro managers, followed by emerging markets, quant macro, and trend following strategies. Discretionary traders are benefiting from rising volatility, political uncertainty, and idiosyncratic events. Systematic strategies remain sensitive to choppy market action, but model positioning has recently reversed to be more aligned with our views on the markets.

Our Top Convictions

Read the Detailed Outlook

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