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Hedge Fund strategy outlook Q3 - K2 Advisors®

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 our clients will help them better understand the rationale for owning funds that invest in hedge strategies.

Q3 Outlook: A Leap of Faith

As we move into the third quarter we find our attention focused on the actions of the U.S. Federal Reserve. The Fed has now raised rates four times as part of a apparent normalization of monetary policy that began in December 2015. From an investment perspective we view the bank’s decision to move rates higher as a positive one; particularly as it pertains to a divergence between U.S. policy and that of central banks globally like the European Central Bank (ECB) and Bank of Japan (BOJ), which remain loose with their monetary programs. This dispersion should create fertile opportunities for active hedge fund managers to capture alpha-centric performance.

From a macroeconomic view, however, we see the Fed’s decision in a more circumspect manner. That is not to suggest we believe the move was wrong; we do not presume to know better than Yellen, et. al. the best course of action. From their seat — and tasked with the mandate of promoting a healthy economy — one could say they had little choice other than to act.

Still, there are those who believe the Fed should not be raising rates when core inflation is so low. In fact Minneapolis Fed President Neel Kashkari disagreed with the decision. Kashkari observed that the market has been sending mixed signals of late — that is tightening labor data but weakening inflation. In a June 16 letter he explained his dissent as follows:

“On one hand, intuitively, I am inclined to believe in the logic … a tight labor market should lead to competition for workers, which should lead to higher wages. Eventually, firms will have to pass some of those costs on to their customers, which should lead to higher inflation.On the other hand, the data are not supporting this story … core inflation is actually falling labor market is tightening.”

So, the data does not entirely support the Fed’s thesis. In some ways it could be said the decision to raise rates reflects a leap of faith. That is faith in economic theory versus reality — because despite labor market tightening since March we do not appear to be moving much closer to the Fed’s inflation target.

In our view there is a certain ‘let’s see what sticks’ mentality involved. We suggest this because frankly who could really know what to expect. The business of economics is decidedly complex. Irrespective of the sophistication or depth of intellect applied to the various models used by modern academics, their analysis will generally fall far short of providing sound insight into real world behavior. In the same way that meteorology has made little progress over the last several decades in improving its probability for weather prediction — despite an exponential spike in computing power over the same period — the business of modeling economies remains, for all intents and purposes, fuzzy at best. With an infinite number of factors at play against a dynamic backdrop of ever evolving markets, predicting cause and effect outcomes is virtually impossible. In the immortal words of Albert Einstein, “as far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.”

Inflation expectations appear flat and may even be drifting lower. Perhaps we should have waited for more data to see if the recent drop in inflation is indeed “transitory” as Yellen’s statements seem to suggest. Perhaps not. Only time will tell.

European Long/Short Equity Vacation

Irrespective of what surfaces in terms of economic growth and inflation in North America, we maintain confidence in the directional tailwind supporting long/short equity trading in Europe.

European Equity Price-to-Book Valuations Appear Favorable

European Equity Valuations Appear Favorable

S&P 500 Total Return Index

STOXX Europe 600 EUR Index

STOXX Europe 600 USD Index

As of May 1, 2017.
Source: Bloomberg, S&P Dow Jones, STOXX. See www.franklintempletondatasources.com for additional data provider information.

European equity markets have continued to benefit from relatively favorable valuations, improving earnings growth, and overall global reflation. With most of the banking issues resolved, Europe appears to be in a position to grow again. Additionally, we anticipate the alpha environment will likely remain robust as certain companies, sectors and countries are positioned to benefit more significantly than others. Despite a lack of market volatility, correlations have declined and dispersion has increased — creating a fertile environment for fundamental stock selection. The significant depreciation of the British pound, for example, has created better separation and earnings variances between those companies that benefit more from exports versus those that do not. And as interest rates start to increase in the region, the environment for long/short investing should improve further.

Over the last several months we have also witnessed interesting sector rotations, such as into financials and technology, while some of the defensive energy sectors and commodity-related investments have lagged. This dynamic has presented managers with the opportunity to employ quality long positions against relatively efficient market hedges.

Central Bank Policy Divergence: A Potential Benefit to Relative Value – Fixed Income

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.

We See Relative Value Opportunities in Fixed Income Based on Prevailing Investor Positioning

We See Relative Value Opportunities in Fixed Income Based on Prevailing Investor Positioning

As of May 1, 2017.
1. The market is being represented by the JPM Domestic HY Index.
Past performance is not an indicator or a guarantee of future performance.
Source: JP Morgan. See www.franklintempletondatasources.com for additional data provider information.

Specifically, managers in this strategy are finding opportunity in two primary areas: crosscountry arbitrage and cross-sector arbitrage. With the Fed now having hiked interest rates four times since December 2015, they are clearly telegraphing their intent to normalize interest rate levels going forward. Simultaneously, the ECB and the BOJ remain somewhat stimulative in their approach. This divergence may create dispersions that present hedged opportunities, such as being short U.S. government bonds versus holding long Eurozone bonds.

Macro CTA

We are optimistic on Macro CTA strategies (“Commodity Trading Advisor” strategies refers to systematic trend following and momentum-type trading) based on a combination of stronger trend following conditions and reduced cross-asset correlations. Low volatility across all major markets remains a headwind (particularly for price-based systematic managers), but we also like the strategy’s low correlation to traditional asset classes and the potential risk mitigating characteristics in certain market environments.

Macro CTA Strategies Tend to Perform Well on the Heels of Major Drawdowns

Merger Arbitrage Spreads Remain Attractive

 

Barclay BTOP50 Index Drawdown (LHS)

Barclay BTOP50 Value Added Monthly Index (RHS)

 

Average Gross Spread1

Average Annualized Spread1

As of May 1, 2017.
Past performance is not an indicator or a guarantee of future performance.
Source: Franklin Templeton.

12-MONTH OUTLOOK SUMMARY FOR Q3 2017

  • Neutral
  • Up Trend
  • Down Trend
StrategyConviction SentimentSummary Statement

Long/Short Equity

We maintain a positive outlook for long/short equity investing, despite maintaining a measured outlook on overall market levels. Given the resurgence of certain trends YTD, including lower stock correlations, higher dispersion and improved alpha generation by long/short funds, we anticipate the alpha environment will likely remain robust and that long/short managers will be able find attractive opportunities on both sides of their books regardless of aggregate market valuations.

Relative Value

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 view for both volatility arbitrage and fixed income arbitrage. With actual volatility at very low levels, the long volatility profile has attractive asymmetry as a complement to other investments.

Event Driven

Corporate activity should remain robust under the new administration, which is expected to employ more business friendly policies – less regulation, lower taxes, tax holiday on cash repatriation, reduced antitrust risk. Merger arbitrage spreads remain attractive while special situations and activism are generally more equity market dependent.

Credit

While rates have remained lower longer than the market originally anticipated, duration risk is still prevalent in the credit markets. Long/short credit managers have naturally shorter duration portfolios and should benefit from sector dispersion when rates do rise. 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

Positive outlook for all three subsectors of global macro strategies. Systematic managers are benefiting from an improved trend following environment and improved cross-asset correlations. Discretionary managers are benefiting from strong fundamentals and greater dispersion in emerging markets, along with a generally benign macroeconomic environment.

Long Short Equity - Europe

European equity markets have continued to benefit from relatively favorable valuations, improving earnings growth, and global reflation overall.

Relative Value - Fixed Income

As rates rise, investors need to reduce duration risk. This creates volatility in the credit markets and presents opportunities for hedged credit strategies to generate performance from long positions and short positions.

Macro CTA

Improved environment for systematic investments due to stronger trend following conditions and improving cross-asset correlations.

For the complete discussion of our Q3 outlook for each hedge strategy, request a copy.

David Saunders

David Saunders
Founding Managing Director

Robert Christian

Robert Christian
Senior Managing Director
Head of Research

Brooks Ritchey

Brooks Ritchey
Senior Managing Director
Head of Portfolio Construction

What Are the Risks?

All investments involve risks, including possible loss of principal. Investment in these types of hedge fund strategies is subject to those market risks common to entities investing in all types of securities, including market volatility. There can be no assurance that the investment strategies employed by hedge fund and liquid alternative managers will be successful.

Hedge strategy outlooks are determined relative to other hedge strategies and do not represent an opinion regarding absolute expected future performance or risk of any strategy or sub-strategy. Conviction sentiment determined by the K2 Research group based on a variety of factors deemed relevant to the analyst(s) covering the strategy or sub-strategy and may change from time to time in the analyst’s sole discretion.

Important Legal Information

These materials reflect the analysis and opinions of the authors on the stated publication dates, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. It is intended to be of general interest only and not 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.