Foreword

In aggregate, hedge funds have delivered strong absolute and risk-adjusted returns throughout 2021. Despite heightened valuations and increased volatility in traditional stock and bond markets, we’re optimistic that these positive trends in hedge-fund performance could continue in the final quarter of the year.

Overall, we see the hedge-fund space as both broad and flexible, which could bode well for fourth quarter performance. Some sub-strategies that we think may have the most positive potential outlooks include merger arbitrage, equity hedge and volatility. In this outlook, we detail our forward-looking ratings for these and other macro hedge fund sub-strategies.

Source: abrdn, September 30, 2021.

HFRI 500 Global Macro

Discretionary thematic
Forward-looking rating: Positive

Our outlook for discretionary thematic remains cautiously positive. We continue to see a global recovery divergence theme playing out, which will likely continue in 2022. In our view, regional and country-specific recoveries from this pandemic have to do with a few key factors. These include the depth of recession during 2020 (and if it bled into 2021), the speed of vaccination rollouts and the ability to avoid new lockdowns.

This macro backdrop should allow regional specialists to identify attractive directional and relative-value opportunities, particularly in currencies and interest rates. We also expect both technical and fundamentally driven traders to benefit in this environment. However, we still prefer more fundamentally driven traders over those with an overly technical bias. Thus, data releases and policy responses remain in focus as global economies unevenly recover from the Covid-19 pandemic.

Given the vast opportunity set, we are aware of certain risks. For example, the risk of style drift. Managers might want to do too much in this environment, potentially building outsized positions or trading in areas where they lack expertise. We have also noticed that some managers are overly focused on higher inflation/US rates trades, which makes them more vulnerable to potential shifts in developed market policy paths.

The US Federal Reserve (Fed) had a chance to announce tapering of asset purchase at both the August meeting in Jackson Hole and the September Federal Open Market Committee (FOMC) meeting. While tapering could be a catalyst for large gains, the Fed did not announce that it would be implementing this policy at either gathering. It’s possible that tapering could begin before year end, but whether or not this comes to pass, as these events get more telegraphed and priced into markets, we think that the range of outcomes that could lead to massive positive performance could shrink. In fact, the range of potentially negative scenarios for managers could grow, which inspires us to be more cautious.

Systematic diversified
Forward-looking rating: Neutral

Our outlook for systematic diversified remains neutral. We expect that the ongoing Covid-19 pandemic will keep levels of global economic divergence high. So, we remain concerned that asset prices and fundamental data may not exhibit stable trends over the next few quarters.

However, with a promising vaccine rollout in most parts of the developed world and thus the end of the pandemic closer, we expect to start seeing some normalization into the year end, which would encourage us to review our outlook. We therefore continue to favor strategies with a short-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. However, we’re more concerned about managers with sizeable long commodity exposures. These exposures worked well in the second quarter thanks to supply-chain issues and pent-up demand, for example. But these driver are likely to recede.

We also expect multi-strategy systematic macro managers slightly to outperform more fundamentally driven managers over the near term. This is because 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, remains relatively low.

Right now, managers only express either moderate-long or short exposure. This could be an area where managers may consider allocating more. Positioning in equities and emerging market (EM) currencies is already elevated. As greater certainty on monetary and fiscal policies emerges globally and economic data become less extreme in the coming quarters, 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’re constructive on the outlook for equity hedge overall, but the strategy isn’t without its risks. Market and factor beta have been key drivers of equity hedge performance in a macro-driven equity market environment. As the market remains hyper-sensitive to Covid developments and their implications for global economic growth (and its implications for market leadership), we expect macro and associated style factors to continue to be critical to hedge fund performance in the near term at least.

We think that equity-hedge managers with a “top-down” component to their investment process could be in good shape. The strongest ones have proved adept at navigating a rapidly evolving economic landscape to capture much of the market upside associated with market recovery. At the same time, they’ve insulated their portfolios from the worst of the growth-to-value-rotation-induced market unwinds.

The alpha environment has been extremely challenging. Managers focused on minimizing factor exposures and enabling alpha/idiosyncratic risk to dictate performance have generally found it difficult to produce satisfactory returns. This is unsurprising in a market driven by incremental economic or Covid-related data. Stocks and sectors move in tandem based on their characteristics, so investors more concerned with owning the “right” type of stocks rather than the best companies may struggle.

At this time, it seems like fundamentals have taken a back seat for many managers. But this dynamic won’t last forever, and there are reasons to believe that company fundamentals, stock picking and alpha will become increasingly relevant from here. A market which has been characterized by ignorance of company fundamentals, by definition, creates a tremendous stock-picking opportunity. Managers who try to capitalize on this could potentially generate abnormal levels of alpha. Stock prices that are out of sync with fundamentals could therefore create the ideal long/short environment for stock pickers.

The macro-driven environment we’ve witnessed since the onset of the pandemic has been characterized by a significant multiples expansion. We’ve now entered a stage in which, as economic growth is realized, companies have to justify lofty valuations by demonstrating real economic value. At some point, stocks will be rewarded and punished according their own fundamentals. Calling the exact timing of this is impossible, but we do believe there are encouraging signs of (gradual) inflection in the market.

Market leadership and frequent rotations have been described in terms of shifting preferences — cyclicals versus defensives, value versus growth, Covid winners/losers versus re-opening baskets. Each of these narratives are intertwined, but have its own cyclical and secular underpinnings. Understanding these dynamics and configuring portfolios accordingly has driven returns for those equity-hedge managers that have outperformed in the pandemic.

Market rotations, especially of the value versus growth variety, are not unique to the Covid market environment. In fact, they’ve been challenging equity-hedge managers with increasing frequency in recent years. And rotations are likely to remain a key feature of markets (and equity-hedge returns) as the global economic picture becomes clearer. But, given the strong run that cyclicals and value have enjoyed (and the associated valuation reset) and the reflation trade clear-out in the weeks following the inflation “shock” in mid-May, being on the “right” side of such rotations with the “correct” style tilts should become increasingly less critical to returns. This would reduce factor volatility and allow idiosyncratic risk to dictate performance. As always, it’s critical to maintain a diversified roster of equity-hedge managers across economic styles and across the “pure alpha” to “flexible net” (more top-down influence) spectrum, as well as to blend equity-hedge allocations in portfolios as appropriate.

Event driven

Activist
Forward-looking rating: Positive

We maintain a positive outlook for the activist strategy. Improved shareholder engagement remains an important topic for global policymakers. We expect the engagement of traditional investment managers to continue to affect the balance of shareholder power as passive investing continues to grow in popularity. Index funds managed by some of the largest firms have larger ownership stakes and voting influence, especially as it relates to governance and stewardship principles.

In a more shareholder-aware society, smaller activists are starting to see success with larger corporations, especially when their campaigns center on popular topics like environmental, social and governance (ESG). The “G” has always been an area of focus for activists. This has often come in the form of challenging stagnant structures or entrenched management teams and boards. However, the “E” and the “S” are getting more attention today than ever before. We’ve already seen an upward trend in shareholder proposals that aim to address climate initiatives. In one example earlier this year, a largely unknown activist, Engine No .1, won three board seats on Exxon’s board despite owning less than 1% of the outstanding shares.

Mergers and acquisitions (M&A) momentum continues to drive a large portion of activist activity and is a popular tool for activists to create value. This is because campaigns with M&A-related theses can be less risky and have shorter timeframes compared to traditional operationally led turnarounds. which tend to carry a higher level of uncertainty and longer timeframes.

Given the length of time that managers typically require to implement their activist agendas, hedge-fund investors should consider any investment over a multi-year timeframe of at least three-five years. We favor managers who can maintain an active pipeline of new positions, and can employ a hedging strategy to offset any potential concentration risk.

Special situations
Forward-looking rating: Neutral

We maintain a neutral rating for special situations. Our positive house view on US equities (where special situations managers have the majority of their portfolios) supports the beta component of the strategy’s return. Currently, special situation managers rely on beta to higher-quality names to generate returns. Many of these positions are in companies that have benefitted from post-Covid behavioral and technological shifts. These are typically high-quality growth companies in the technology or consumer discretionary sectors.

However, as we saw in March 2020, special situation positions tend to have high hedge-fund ownership. Fund deleveraging and risk aversion in stressed periods can combine to put pressure on these crowded names and remains a risk in the strategy.

We also temper our strategy outlook because special situation managers have a tendency to get involved in situations where the catalyst(s) may be softer in nature or have yet to play out. Spin-offs are one example where we continue to see extended timelines with an elevated backlog. Only seven spin-offs completed this year, compared to 17 completed spins in 2020 and 12 in 2019.

Special situations managers are increasingly looking to invest in companies across their corporate lifecycles, broadening investment timelines to include investment in private companies. Lately, mangers have initiated positions during earlier funding stages and in late-stage/crossover private opportunities, looking to play company initial publish offerings (IPOs) as significant catalysts.

In this same vein, managers have leveraged relationships to initiate at-risk capital positions in private investments in public equity (PIPEs) and special purpose acquisition companies (SPACs) with high-quality management teams. Regardless of a company’s performance immediately after becoming public, which can be subject to IPO or SPAC market sentiment, managers generally seek to hold these positions as compounding investments, benefiting from a company’s progress as they grow and mature.

We are generally encouraged by this trend into private markets because it allows managers to gain exposure to significant company growth as well as to a broader set of catalysts. However, as hedge fund allocators it is important to monitor the overall level of private investments as it relates to each fund’s liquidity terms.

Merger arbitrage
Forward-looking rating: Positive

We maintain a positive outlook for the merger arbitrage strategy after upgrading it at the start of the year. Despite the fact that we remain in a low interest-rate environment, merger arbitrage managers have opportunities to generate positive returns in line with or slightly above the strategy’s long-term expected returns over the next six to 12 months. These opportunities come from both traditional, announced M&A deals trading at wider spread levels, as well as SPACs trading at attractive discounted levels.

However, we believe that there are increased risks to the overall deal-making landscape that are largely regulation-driven. These types of risks have historically been unpredictable, so, because of this, we place a greater importance on individual deal analysis, selection and trading to seek to generate better returns. There will be a premium across managers for antitrust experience and regulatory connections in Washington, D.C.

Strong North American and cross-border M&A activity has global announced M&A totals on a record pace for 2021 year to date. High CEO confidence, cheap access to debt financing, public companies flush with cash on their balances sheets and private equity firms flush with dry powder — the key pillars of corporate activity — support this high level of deal making.

With all this said, President Biden signed an executive order in July focused on increasing competition and empowering regulatory agencies like the Department of Justice (DOJ) and Federal Trade Commission (FTC) to increase scrutiny of corporate M&A. The Biden Administration has made it clear that it wants to protect the consumer and address anticompetitive practices.

This adds elevated antitrust concerns to the deal-completion process for merger arbitrage investors, which could potentially lead to longer timelines for approval and lower odds of success. However, we must keep in mind that the majority of announced M&A transactions historically close. Moreover, ongoing geopolitical tension between US and China continues to weigh on pending deals, with high uncertainty around deals requiring China antitrust approval, such as the Maxim Integrated Products/Analog Devices deal.

The potential for this type of heightened uncertainty results in more deal complexity and, ultimately, wider spread levels. In fact, we already witnessed a modest uptick in average spread levels (Chart 1) across announced deals starting in June and continuing into July when the DOJ sued to block the Willis Towers Watson/Aon deal, which led the companies to terminate the deal.

At this point, we are unsure if this dampens the steady deal flow that we saw during the first half of the year. If anything, it could impact the hot tech and healthcare sectors, while sectors such as real estate, energy and consumer that were affected the most by Covid-19 may see an uptick in M&A.

Longer-term, sustained high volatility and deal breaks are the biggest risks to the strategy, but we like the defensiveness of merger arbitrage. It has historically performed well versus other hedge fund strategies during volatile periods. This is largely because losses are generally mark-to-market in volatile periods.

Short bouts of volatility that cause spreads in announced deals to widen create opportunities for arbitrageurs, allowing them to deploy capital aggressively and take advantage of wider spread levels. We witnessed this in March 2020, when deal spreads widened to levels last seen during the Global Financial Crisis (GFC). Panic ultimately creates opportunity for arbitrage investors, allowing them to initiate new positions in pending deals and upsize existing positions, which puts them in a position to generate very high returns in a short period of time when these transactions close and the spreads collapse.

Elsewhere, the SPAC market remains relevant and most merger arbitrage managers maintain some exposure. SPAC new issuance remains low compared to the fourth quarter of 2020 and first quarter of 2021. There are still more than 400 SPACs seeking business combinations. SEC regulators are actively looking at SPACs and likely helped halt the prior mania. However, both SPAC new issuance and announced business combinations trended higher in May and June after there was a notable drop off in April. SPACs are also starting to gain relevance in Europe with current listings on Amsterdam, Frankfurt and Paris markets. The Financial Conduct Authority (FCA) recently released new investor protection rules for London Stock Exchange-listed SPACs, which suggests that the UK is next.

The average yield for US-listed SPACs seeking business combinations was near peak levels for the past 12-month period, with most SPACs trading at or below trust value. We believe that merger arbitrage managers who opportunistically buy SPACs at discounted levels and sell before a deal closes may be able to achieve mid-single-digit forward-looking returns. Merger arbitrage has merit as standalone strategy, but can also be additive to a portfolio of traditional announced M&A transactions. This is a conservative strategy with a defined downside.

In the current environment, managers may wish to consider targeting SPACs seeking business combinations with the best-perceived sponsors, as well as buy SPACs with announced deals that have PIPEs big enough to backfill the redemptions and guarantee a backstop. The SPAC universe is becoming more imbalanced and rationality is returning, but this is a good thing. Not all SPACs should trade the same. Looking ahead, we don’t expect to see as strong deal-driven optionality as we saw at the end of 2020 and beginning of 2021, but we do think the market could return to rewarding well-received deals.

HFRI 500 Relative Value

Fixed income - Sovereign
Forward-looking rating: Neutral

Our outlook for fixed income sovereign strategies remains neutral. This is because the opportunity set for bond basis trading in G3 countries has noticeably declined and is best described as average to modest. This less attractive opportunity set for bond basis trading is offset by a moderately more attractive opportunity set for other trading activities. These include strategies to trade around auctions, asset swap spreads and yield-curve trading.

Unfortunately, volatility in these relationships has made returns erratic. For many managers, these strategies do not present a scalable risk allocation, nor the same ability for leverage, consistent opportunity set or catalyst that bond basis trading has, and thus can complement profit and loss (P&L), but will not be able to drive above-average returns. The same applies to other non-traditional fixed-income relative value (FIRV) strategies, such as discretionary macro, volatility, mortgage and cross-asset volatility trading.

Overall, it is a modest environment for FIRV managers. The strategy goes through cycles in terms of opportunities and the current situation feels like a hiatus — one of the periods of low opportunities between periods of really good opportunities. While the Fed didn’t announce tapering at Jackson Hole or the September FOMC meeting, we hope that it could be implemented in 2022. Tapering would provide the catalyst for dislocations and higher volatility that will create significantly better opportunities.

Although we think the removal of Fed accommodation from markets will ultimately be very beneficial for the strategy, we do question whether the announcement of the first stage, tapering, may actually already be priced in or so well telegraphed that it won’t be the catalyst that many managers expect.

So, for the moment, we believe a rating of neutral is still appropriate for the strategy. In this context, manager selection will be important, and we expect the more diversified managers to outperform more narrowly focused managers both in terms of strategies and geographies traded.

Fixed income - asset backed
Forward-looking rating: Neutral

As we enter the second half of 2021, the macro and policy backdrop for structured credit and related specialty finance strategies continues to look highly supportive. While the fundamentals are strong, much of the recovery is priced in, with spreads across many assets having fully recovered and often at all-time tight levels.

Residential mortgage-backed securities (RMBS) – The US housing market has strong fundamentals, with home prices up year over year through September, resulting in declining loan-to-value ratios and lower delinquencies. However, this is priced in to the space with new issue credit risk transfer (CRT) spreads very tight and often unattractive to new managers. There is more return potential from legacy RMBS, although the paper is increasingly hard to source, and it is generally becoming a smaller part of managers’ growing funds/AUM.

Asset-backed securities (ABS) - We feel consumer ABS is the most attractive of the liquid asset-backed sectors, buoyed by a healthy consumer and financial technology. New lending platforms have emerged that leverage artificial intelligence and algorithms to make personal loans over the internet, consolidate debt and generate 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 to acquire short-duration unsecured loans at a mid-single-digit unlevered yield.

Commercial mortgage-backed securities (CMBS) – We remain somewhat cautious on the CMBS opportunity. We believe the risks of Delta Covid variant are not priced in to the office, retail and hotel markets. We remain more constructive on multi-family housing, although this market has also recovered. Wide open capital markets have bought time for many stressed assets, but with Delta likely to slow the recovery in travel and new ways of working transforming the demand for office space, a V-shaped recovery is unlikely to materialize.

Speciality finance – Specialist lenders continue to have a solid opportunity set because there are inherently large barriers to entry due to the unique skill set and industry relationships required. In many cases, these niche opportunities have limited institutional capital because they’re complex. This state of play is likely to set up managers for above-average risk-adjusted returns over the next 12 months. However, as Covid-19 demonstrated its ability to disrupt the aviation industry, this space is not immune to an economic shock.

Fixed income – corporate
Forward-looking rating: Positive

Our outlook on fixed income – corporate remains positive. We see good opportunity in the recovery phase of the credit cycle, across credit selection strategies as well as event-driven or capital structure arbitrage opportunities. For example, there may be long opportunities to buy performing bonds and loans in heavily Covid-affected and in some cases ESG-impacted sectors, while potentially shorting the equity with derivatives.

Issuance and trading volumes remain robust, with net issuance increasing through 2021 driven by higher levels of M&A and other corporate activity. Following the record bond issuance in the last twelve months, we think managers that can sort through the layering across the capital stack may be well positioned to outperform. Fundamental analysis is more important than ever. Second-lien loans may offer higher yields and opportunity, yet their recovery values have reached historic lows and are expected to remain poor. Across the derivatives landscape, we also see attractive trading opportunities in high-yield mezzanine and investment-grade equity tranches.

Finally, we are excited about the opportunities emerging in systematic credit strategies which, while underperforming their longer-biased peers recently, could potentially benefit when higher levels of dispersion and volatility return to the credit markets. The main factor that could hamper the performance of some strategies is the fact that generic market spreads are rich and valuations are tight as the bull phase of the credit cycle continues.

Fixed income - convertible arbitrage
Forward-looking rating: Positive

We are keeping our positive outlook on the opportunity set for convertible arbitrage managers, as many of the same trends that drove strong returns in 2020 remain in place. The key elements that support this positive view are a robust new issue market with increased breadth of expected issuers across sectors, reoccurring volatility shocks and a highly accommodative monetary and fiscal policy backdrop.

While new issuance levels for the remainder of 2021 will not reach the historical pace achieved in the first quarter this year, the trend is expected to continue. This is because companies need to raise convertible debt and conditions such as low interest rates, high stock prices, and attractive terms remain favorable. With volatility for many names in the universe now closer to longer-term, pre-Covid historical levels, the asset class may offer attractive risk/return opportunities.

A renewed bid for growth stocks could lead to gains in parts of the market that have been under pressure in recent months. The uneven path of the global recovery, thanks to differences in vaccination rates and divergent policies, have resulted in a large dispersion in terms of the outlook for growth. The rise of new, potentially vaccine-resistant variants and an alarming increase in Covid cases leaves markets vulnerable to sharp volatility shocks, potentially presenting juicer gamma trading opportunities for managers with an opportunistic tilt.

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. The volatility of the volatility subsector has been elevated 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. We continue to anticipate high levels of global economic dispersion and view the environment as ideal for our relative value focused volatility managers.

For directional/tail-risk managers the outlook appears weaker. Though recent declines in absolute levels of volatility have reduced the cost and increased the convexity of hedging strategies, we believe that the global recovery will continue to act as a headwind for such strategies in the absence of more concerning coronavirus mutations and outbreaks. During spikes in volatility, it could be a good time for portfolios to take profits on their tail hedges, as we continue to expect a more bullish economic environment through the last quarter of 2021.

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.

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