Foreword

This quarter’s report was written before the tragic conflict unfolding in Ukraine began. The associated economic, geopolitical and humanitarian impact from the Russian invasion has impacted not only eastern Europe, but also the rest of the globe. At this time our thoughts are with the people of Ukraine and we stand united with them.
On the macroeconomic side of this tragedy, while the coordinated and united actions of governments and corporations has demonstrated a clear sense of unity, markets have also delivered a clear message — risk assets have declined. Fears of escalation, higher inflation and disruption to supply chains have put even greater pressure on a world attempting to emerge from the unprecedented effects of the Covid-19 pandemic.

Although recent events have caused markets to re-price risk assets, our team felt the underlying driver and outlooks across the different hedge-fund strategies remained intact. One of the core pre-invasion themes we focused on, how to generate returns in a rising interest-rate environment, remains a central theme.

Table 1: Forward-looking ratings

Source: abrdn, March 2022.

HFRI 500 Global Macro

Discretionary thematic
Forward-looking rating: Positive

Our outlook for discretionary thematic remains cautiously positive. The Covid-19 pandemic and Covid-vaccination uptake are becoming less and less of a factor in the context of macro hedge fund returns and our outlook.

Instead, inflation and central banks’ interest-rate policies have become dominant themes in 2022. We believe that this backdrop should continue to be supportive and allow specialists to identify attractive directional and relative value opportunities, particularly in interest rates and currencies.

Chart 1: US Interest Rate Implied Volatility
Since last autumn there has been a clear trend towards higher interest rates volatility. We expect volatility to settle at a higher band than the average in 2021 and potentially to keep rising further.

Source: Bloomberg, March 2022.

We expect both technical and fundamentally driven traders to benefit in this environment, although we still prefer more fundamentally driven traders over those with an overly technical bias. From the regional perspective, we still anticipate that managers who are tilted more toward emerging markets will see more volatile performance in 2022, as geopolitical tensions in Ukraine continue, inflation spikes persist and developed market central banks continue to surprise market participants at least in the first half of this year.

While the opportunity set remains broad, we are cognizant of certain risks. For example, managers could be overly focused on US rates trades, and thus be vulnerable to choppy markets and quickly changing market sentiment. While at the time of writing, the market is pricing in between five and six interest-rate increases from the US Federal Reserve (Fed) this year to tame inflation, aggressive tightening can undercut the economic recovery and result in a policy reversal.

Thus, more tactical and nimble and less aggressive managers are likely to operate better in this environment as the world shifts its focus from Covid-19 recovery to sustainable economic growth. While we anticipate a wide range of performance outcomes for discretionary managers in the near term, we still expect that the start of interest-rate hikes by most developed countries will create more opportunities for discretionary macro managers and will result in average positive performance.

Systematic diversified
Forward-looking rating: Neutral

Our outlook for systematic diversified remains neutral. Consistent with our expectation that inflation and rising interest-rate themes will dominate in 2022, we remain concerned that asset prices and fundamental data may not exhibit stable trends in the short term.

However, with most major central banks expected to raise interest rates, or at least to indicate a clearer policy in the short term, we hope to start seeing some normalization in 2022, which would encourage us to review our outlook. We therefore continue to favor strategies with a shorter-term time horizon that can ebb and flow with whipsawing markets.

We also believe that trend followers can generate strong gains, if recovery momentum persists. We are more concerned about managers with sizeable long commodity exposures. These exposures benefitted from pent-up demand and supply-chain issues in 2021, but are likely to recede in the coming quarters.

In our view, it’s unlikely that managers with overweight positions in energy will be able to replicate their strong gains this year.

We also expect multi-strategy systematic macro managers to outperform more fundamentally driven managers over the near term as price based inputs will be the first to reflect changing market sentiment. We continue to observe that conviction in fixed income, which has historically been a large driver of systematic returns, and still remains relatively low, with managers currently expressing only either moderate long or short exposure. This could be an area where managers allocate more, as positioning in equities and commodities is already elevated.

With inflation and economic data becoming less extreme in the near term and the emergence of clearer monetary and fiscal policy globally, we could see the case for increasing the conviction in systematic strategies as longer-term trends potentially establish themselves across both fundamental and price data.

HFRI 500 Equity hedge

Equity hedge
Forward-looking rating: Positive

We remain constructive on the outlook for equity hedge overall and maintain a positive rating. We think that the market environment going forward is more likely to reward bottom-up stock picking than it has since the onset of Covid-19.

Market and factor beta have been key drivers of equity hedge performance in a market quick to pivot on incremental Covid-related news. In that environment, equity hedge managers with sustained or flexible net exposures, and particularly those willing and able to trade proactively between sectors and styles, outperformed. While the ability to remain nimble will continue to be valuable amid heightened macroeconomic uncertainty, we believe those managers that have struggled to generate “pure alpha” should see improved results.

While Covid-19 itself feels a less dominant driver of incremental market moves, in developed economies at least the market is now grappling with the consequences of the monetary and fiscal largesse required to support the global economy. Inflation and its consequences for interest rates will influence the direction, strength and shape of equity market performance from here.

Should central banks avoid tipping the economy into a recession and economic growth remains robust, the equity bull market is likely to continue. However, in an environment with robust economic growth in combination with higher interest rates and inflation, equity returns should expect to be more muted. This type of environment would support stock picking because dispersion tends to be more micro than macro driven in such scenarios.

The “normal” market dynamic, which has been severely disrupted since March 2020, contributed to record poor alpha generation across the equity hedge space during the pandemic. But going forward, as we move on from Covid, we believe that earnings will become a more important driver of individual stock returns.

The growth versus value debate has only intensified, with the aforementioned macroeconomic variables likely to determine the shape of equity market performance. The combined level of GDP growth, interest rates and inflation will influence market leadership. And while the equity market has been leaning toward value stocks and shunning growth stocks with lofty valuations in anticipation of a higher rates environment, market leadership from here is less certain.

Chart 2: Russell 1000 Growth vs Value: Rolling 1yr Correlation
The growth vs. value debate has intensified, with rates, inflation and the strength of the global economy likely to determine market leadership from here.

Source: Bloomberg, March 2022.

But we would argue that these macro considerations are more “normal” cyclical variables for equity hedge managers to contend with, relative to the types of predictions and proactive trading across sectors and styles that an unusual pandemic market environment demanded. In this sense, whether growth or value leads the market from here is less relevant.

A good stock-picking environment will rely on subdued factor volatility relative to the extreme levels at the height of the pandemic. Against this backdrop, idiosyncratic risk can be the main driver of stock prices.

Sharp intra-market rotations between styles, such as the one witnessed in January 2022, remain the key risk to equity hedge performance. These could be caused by, for example, poorly communicated central bank policies, disorderly movements in rates or exogenous risk factors, including escalating geopolitical tensions.

As always, we believe that it’s critical to maintain a diversified roster of equity hedge managers across economic styles. We aren’t advocating a shift away from managers with growth biases, but we’re discussing with such managers more intently their perspectives on the issues at hand and their positioning, as well as looking for signs of inflexibility/stubbornness.

We believe that the extremity of the growth/value rotation in January presented extremely compelling long and short opportunities for growth-biased managers, especially those most exposed to longer-run secular growth themes. We think that healthcare managers, especially those that are focused on life sciences and have been able to protect capital in the healthcare rout, are particularly interesting right now.

We also think the energy-transition theme is presenting some exciting opportunities. We still value “flexible net” (more top-down influence) managers while the economic landscape remains unclear, but we think that the performance of bottom-up stock pickers, including pure alpha managers, is likely to improve from here. Sector specialists remain our preferred way to blend diversified alpha sources within equity hedge allocations.

Regional diversification may also be a good way of balancing any US growth bias that equity hedge allocations have. Europe (more value/less growth) and China (strong potential for stimulus) are among our preferred regions outside of the US.

Multi-PM platforms should remain core to equity hedge allocations. Quantitative managers with significant weights to fundamentals-based models are incrementally more attractive in this environment and we expect less divergent performance between these managers and quantitative managers that focus more on beta and sector allocations, which outperformed significantly in 2021.

Table 2: Hedge-fund index returns

Source: abrdn, HFR, March 2022.

Event driven

Activist
Forward-looking rating: Neutral

We have tempered our outlook for the activist strategy, and downgraded it from positive to neutral. A neutral rating indicates that we expect forward-looking returns in line with the strategy’s long-term historical average. While our house view is still positive on the overall equity markets, we don’t anticipate that returns will be as strong as they’ve been in recent years, thereby removing the beta tailwind component of the activist strategy.

This said, with an increased focused on shareholder democracy, such as better market transparency and evolving voting policies, we expect activist managers will continue to launch new campaigns. This could be especially true of those with M&A-related, break-up or more traditional board-room accountability theses, as well as campaigns that target trending environmentally related topics.

Improved shareholder engagement remains an important topic for global policymakers. In the US, the SEC recently called for the adoption of a universal proxy rule. Proxy votes traditionally have binary choices when it comes to nominating new board directors — voters can elect the proposed company slate of directors or the dissenting slate. The proposed universal proxy rule, which does not take effect until the end of August 2022, would allow voters to elect directors regardless of who nominated them.

Such a change could lead to a significant increase in the number of contested board room elections by creating a lower barrier to entry for nominations for traditional activists and new entrants. In fact, this aligns with the general trend that activism is becoming more mainstream.

The impact of these changes, however, still relies on the underlying shareholder base to vote. We have discussed in the past how the engagement of traditional investment managers continues to affect the balance of shareholder power as steady inflows into passive strategies have fueled ownership concentration in the index fund complexes.

Index funds managed by firms such as BlackRock, State Street and Vanguard have larger ownership stakes and voting influence especially as it relates to governance and stewardship principles. However, in October 2021, BlackRock announced that it intended to extend proxy voting decisions to its ultimate end-investors, and a decision like this has the potential to cause other investment managers to follow suit.

Elsewhere, other developments could impact how activists build positions in companies as regulators continue to push for greater market transparency, such as increased ownership disclosure requirements. For example, the SEC proposed two changes to ownership disclosure requirements in 2021. First, it proposed accelerating the deadline requirement to disclose a 5% ownership stake in a company (13D filing), which is currently 10 days. And, second, it proposed that investors would need to disclose swap positions representing more than 5% of ownership stake as investors are currently not required to file a 13D if the position is held in derivatives without owning common shares.

Special situations
Forward-looking rating: Neutral

We maintain a neutral rating for special situations. We have historically tempered our strategy outlook in this space because special situation managers tend to get involved in situations where the catalyst(s) may be softer in nature or have yet to play out. However, the main reason we maintain a neutral rating for our current outlook is because the special situation strategy, like the activist strategy, has a large beta component in its returns, which we don’t expect to be as strong looking ahead.

We don’t expect there to be as many popular higher-quality pandemic recovery trades, an area from which managers generated strong returns in 2021. Additionally, special situations managers have increasingly looked to invest in companies across their corporate lifecycles over the past year, broadening their scope to include investment in private companies and looking to play company IPOs as significant catalysts. While we do expect this trend to continue, the high-return opportunities are likely to be fewer and far between as the IPO market comes off a high and speculative growth companies fall out of favor with the prospect of higher interest rates.

This said, with the resurgence of value stocks so far in 2022, we could see a return to more traditional value-plus-catalyst opportunities. For example, the annual volume of corporate divestitures has been steadily increasing and are expected to be an area of continued activity as both companies reassess their portfolios and look for ways to increase value and activist managers urge companies to consider a break-up to streamline their businesses.

Merger arbitrage
Forward-looking rating: Positive

We maintain a positive outlook for the merger arbitrage strategy. Managers continue to navigate a complex deal environment with heightened regulatory scrutiny. Regulatory risks have historically been unpredictable, and because of this, we place a greater importance on individual deal analysis, selection and trading.

Elevated antitrust concerns to the deal-completion process can mean longer timelines for approval and lower odds of success (though we must keep in mind that most announced M&A transactions historically close). Additionally, ongoing geopolitical tension between US and China continues to weigh on pending deals, with high uncertainty around deals requiring China’s antitrust approval.

However, increased uncertainty and complexity for announced deals leads to wider deal spreads and creates more mispricing opportunities. In fact, we continue to see a modest uptick in average spread levels. We even spoke to one manager who has a sub-book of announced deals it thinks will close, but that are trading at an average 28% gross spread.

Many believe that the M&A market has largely adjusted to the aforementioned risks and, with a backlog of deals that didn’t close in 2021, there is now more opportunity to generate returns. US regulators remain the biggest question mark as we enter 2022, and it is possible antitrust enforcement could become more aggressive as we approach US midterm elections. Overall, M&A activity should have a sustained tail with cross-border M&A rebounding and with more public companies.

Additionally, merger arbitrage is one of the few investment strategies that is positively correlated with interest rates. And with the prospect of rising interest rates, the spreads on deals and rates of return could increase as well.

Distressed
Forward-looking rating: Negative

We are downgrading the outlook from neutral to negative. This is less of a reflection in a worsening outlook for the strategy, and more of an expectation that the one-two year base case for the US will be a continuation of the status quo.

Perhaps the biggest change from last quarter is that we no longer expect new major Covid-19 variants to put the global economy at serious risk, at least for the next six months. In the US, corporate default rates continue to make new multi-year lows and default rates are projected to remain under 1% in 2022, well below the long-term average of 3-4%.

Early projections for 2023 suggest default rates only slightly exceeding 1%. These market conditions are representative of the low-default regimes in the periods leading up to the Global Financial Crisis (2004-07) and following the crisis (2010-13). Today, there is approximately $10 billion of US debt trading at distressed levels (below 70 cents) and about $35 billion trading at stressed levels (below 90 cents), making up less than 2% of the approximately $1.5 trillion market.

While the US opportunity set in distressed is benign, we see greater opportunity in emerging markets, and China in particular. In Asian high yield, more than 40% of the issues are trading at distressed levels, with a large share coming from Chinese property developers. Moreover, single B spreads between EMs and the US are at multi-year wides. China has never experienced a classic distressed cycle, making the path forward unclear but the potential opportunity wider.

HFRI 500 Relative Value

Fixed income - Sovereign
Forward-looking rating: Positive

We are upgrading our outlook for fixed income relative value strategies to positive. The upgrade to the rating is predicated upon the fact that the opportunity set for bond basis trading in G3 countries is notably improved. Plus, we expect it to improve further now that the Fed is decidedly moving toward interest-rate hikes and balance sheet run-off. In addition to the Fed, the Bank of England has already started an interest-rate hike trajectory and is also discussing balance sheet reduction. The European Central Bank (ECB) is further behind in the process, but rhetoric has turned marginally more hawkish in recent weeks as the ECB also faces persistent above-target inflation in the Eurozone.

Source: Bloomberg, March 2022.

Consistent with history, we would expect central bank action to be supportive of the opportunity set for fixed income relative value funds as it creates more volatility around each point on the yield curve. This would also create higher flows through various fixed-income instruments as investors adjust positioning. The Fed bringing active balance-sheet reduction forward is also a notable tailwind for the strategy because, everything else being equal, it will likely cheapen the bonds that the Fed will sell relative to nearby bonds. As the Fed has mostly bought off-the-run bonds, managers expect these securities to cheapen relative to on-the-run bonds and this can be traded either directly through yield-curve arbitrage (e.g., tight butterflies) and asset swap spreads positions, as well as widening the choice of cash bonds to use in basis trades and widening the basis.

Managers also expect the announced reduction in the ECB’s monthly purchases potentially to increase volatility in peripheral European bonds (PEPP program ending in March 2022 and APP program purchases to be reduced to EUR 30bps a month in the third quarter and EUR 20bn from October 2022). In this context, we would also expect the opportunity set for other strategies employed by these funds, in particular macro ones, to be supportive of manager’s ability to generate performance.

Fixed income - asset backed
Forward-looking rating: Positive

We are upgrading our outlook for asset-backed strategies to positive because we believe the strategy is well positioned for an inflationary environment due to rising underlying collateral values and cash flows. We also see better risk-adjusted yields than other areas within credit, likely a consequence of the embedded “complexity premium.”

Residential mortgage-backed securities (RMBS) – Legacy RMBS spreads still remain wider than pre-Covid levels, despite improving fundamentals over the last two years. The pandemic has accelerated demand for single-family homes outside of city centers, and millennial first-time buyers are entering their peak home buying age of 32. These dynamics have supported HPA and in turn reduced severities in collateral, while low interest rates have increased prepayment speeds.

In new issue RMBS, the opportunity is attractive in agency credit risk transfer (CRT) where the GSEs (government sponsored entities) are expected to issue $30b in 2022, more than double 2021 levels. This market is still recovering after being significantly oversold due to mortgage REIT deleveraging in 2020. Meanwhile, non-agency prime faced less selling pressure and offers an average opportunity set today. Both sub-sectors are expected to benefit as Covid-19 forbearance rates continue to decline in 2022.

Asset-backed securities (ABS) - We feel that consumer ABS is the most attractive of the liquid asset-backed sectors, buoyed by healthy consumer appetite and financial technology. New lending platforms have emerged that leverage artificial intelligence (AI) and algorithms to make personal loans over the internet, consolidate debt, and interest-free installment loans.

This new class of originators can underwrite and service loans more efficiently and at a lower cost than the incumbents. Structured credit managers are able to set up master loan purchase agreements with these originators and acquire short duration unsecured loans at a mid-single digit unlevered yield. Furthermore, high nominal wage growth and accumulated consumer savings have led to a lower delinquency rate.

Commercial mortgage-backed securities (CMBS) – We are constructive for the CMBS opportunity set. Performance across multifamily and industrial properties is expected to remain robust, with rent increases well above inflation. We also expect office and retail to benefit from the inflationary environment from both a valuation and cash-flow perspective, but expect more differentiation between high- and low-quality properties.

Class A office property in city centers, growing suburbs, and property customized for biotech and media production are expected to outperform older properties in less desirable locations. Similarly, high-quality retail assets are likely to outperform, and we expect a recovery in demand and for in-person experiences to provide broad support to the sector in 2022.

Fixed income – corporate
Forward-looking rating: Neutral

We are downgrading the outlook from positive to neutral on the basis of a rising interest-rate environment and potentially higher volatility and wider spreads following more than 18 months of the beta trade. On the back end of expected volatility, we anticipate new event-driven or capital structure arbitrage opportunities to emerge.

Across the derivatives landscape, we continue to see attractive trading opportunities in high-yield mezzanine and investment-grade equity tranches. However, the risk-reward profile is less compelling after strong performance in 2021. Finally, we remain optimistic on systematic credit strategies which , could potentially benefit from higher levels of dispersion and volatility returning to the credit markets in the future, even though they’ve underperformed their longer-biased peers recently. Year to date, floating-rate paper continues to see strong investor demand, while bond outflows could pressure pricing and hamper new issuance.

Fixed income - convertible arbitrage
Forward-looking rating: Neutral

We’re reducing our outlook to neutral for convertible arbitrage strategies. Convertibles are typically less sensitive to interest-rate risk than other types of bonds and have historically performed better than traditional fixed-income assets while cushioning equity market volatility during periods of rising rates. Furthermore, since convertibles are typically issued with lower coupons than non-convertible debt, they can be seen as an attractive choice for issuers in a rising interest-rate environment.

However, after robust issuance in 2020-2021, we expect new issuance and the market size to shrink in 2022. Meanwhile, arbitrage strategies make up an estimated 38% of the universe and growing, particularly in healthcare and technology, serving to tamper our risk-adjusted return expectations for 2022.

Volatility
Forward-looking rating: Positive

Our outlook for volatility remains positive. Within volatility, we remain bullish on strategies with a relative-value bias but have a negative outlook for directional/tail-risk strategies. Volatility has remained in an elevated range since the February-March 2020 spike, suggesting that volatility events have remained more common. These levels have continued despite a downtrend in implied volatility across asset classes.

Regardless of the path for volatility, relative-value managers will be able to take advantage of this due to their agnostic approach to the direction of volatility and ability to express trades around the CBOE Volatility Index (VIX) term structure. The uncertain path of interest-rate hikes due to persistently high inflation levels, geopolitical tensions in Ukraine and the shift in monetary policies, along with the ongoing (but somewhat fading) Covid-19 concerns leave markets vulnerable to sharp volatility shocks which makes this environment ideal for our relative-value focused volatility managers.

For directional/tail risk managers the outlook remains weaker. The recent uptick in absolute levels of volatility have slightly increased the cost and reduced the convexity of hedging strategies. During spikes in volatility, portfolios may wish to take profits on their tail hedges, as we continue to expect a bullish economic environment in the short to medium term.

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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.