Third Quarter Hedge-Fund Strategy Outlook: K2 AdvisorsJul 26, 2018

In their third-quarter (Q3) 2018 outlook, K2 Advisors’ Research and Portfolio Construction teams share their views on rising US interest rates and other macroeconomic factors that could present both challenges and opportunities. They believe offering these insights will help investors 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 Perspectives we’ve ever written was the June 2014 issue, where we referenced Roy Scheider’s memorable line from the 1975 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 take a bite out of growth, some investors may start to feel a downward market 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.1 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 we believe 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. The chart below illustrates the historical relationship between HFRI Fund Weighted Composite Index alpha levels and US 5-year Treasury yield levels.

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 annualised 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.

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 (EM) 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 believe both approaches are favoured 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 US equities continue to benefit from a strong economic tailwind, long/short equity managers are also benefitting 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.

The comments, opinions and analyses are the personal views expressed by the investment managers and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The information provided in this material is rendered as at publication date and may change without notice, and it is not intended as a complete analysis of every material fact regarding any country, region market or investment.

Data from third-party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information, and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered by FTI affiliates and/or their distributors as local laws and regulations permit. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction. 

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. 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. 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, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets.

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1. Alpha measures the difference between a fund’s actual returns and its expected returns given its risk level as measured by its beta. A positive alpha figure indicates the fund has performed better than its beta would predict. In contrast, a negative alpha indicates a fund has underperformed, given the expectations established by the fund’s beta. Some investors see alpha as a measurement of the value added or subtracted by a fund’s manager.