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Hedge Fund strategy outlook Q4 - 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 investors and financial advisors will help them better understand the rationale for owning retail mutual funds that invest in hedge strategies.

Q4 Outlook: Two Sides to Every Story — and the Truth

In a recent Bloomberg interview legendary investor Howard Marks of Oaktree Capital said that investing is “never black or white, in or out, risky or safe.” He suggested that investing is about continually calibrating your portfolio across a spectrum of risk — from aggressive to defensive. We could not agree more.

The media likes to hear market calls. They like pundits who say “get out now,” “buy now,” or “it’s time,”etc. We don’t believe anyone can ever be that certain. Most of the time the correct action is somewhere in between. We can never know what the future will hold, but we can get a sense of potential outcomes by looking at what the past gave us, and where we stand in the present. The amount you have invested, your exposures across various asset classes and sectors, and the presumed riskiness of each in the context of the current market. These are all things we can consider.

So where do we stand today? From our perspective things are looking a bit frothy. Again, this is not a market call. This rally could continue on for another year or even longer — who could know? What we do know is where we are relative to historical context. Consider the equity markets for example. The chart below shows the Cyclically Adjusted Price-to-Earnings ratio (CAPE), which is a way of assessing the value of stocks in the S&P 500 Index.

Things are Looking Pricey...

Cyclically Adjusted Price-to-Earnings Ratio for S&P 500 Index
January 1881 - September 2017

Cyclically Adjusted Price-to-Earnings Ratio

Source: Data are from Robert J. Shiller, Irrational Exuberance, 2nd Edition, 2005, as updated by the author through 09/01/2017

The CAPE has only been this high three times before: 1929 (leading to the Great Depression), 1999 (during the dot-com bubble), and in 2007 (during the housing bubble leading up to the Great Recession).

The point is, while we cannot predict market tops or bottoms, we can be prudent in how we position portfolios contextually. Perhaps now is the time to consider dialing back risk to some degree. We believe the easy money in this cycle has already been made. Perhaps it’s time to ‘risk adjust’ portfolios and emphasize ‘alpha markets,’ where hard work and skill may add to returns without significantly adding to risk exposures. Quality ‘beta markets’ that may offer low-risk and steady returns are, in our view, in short supply today. As Marks said, “it’s always about how it’s priced. . . . when we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.” 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.

Dialing up Long/Short Equity Global

We maintain a constructive outlook for long/short equity investing, despite our measured outlook on overall market levels. We have adjusted our focus from Europe to global nonsector.

We believe certain trends such as stocks reacting to fundamentals, lower stock correlations, and increased dispersion are likely to continue to be tailwinds for long/short equity performance over the next 12 months. Corporate earnings and economic growth also remain robust — most notably in the U.S.

Average Subsequent 52-Week Hedge Fund Long Alpha by Net Exposure Deciles
January 2009 -Spetember 2017

Hedge Fund Long Alpha by Net Exposure

Past performance is not an indicator or a guarantee of future performance.
Source: Morgan Stanley Prime Brokerage. Data sample includes U.S. L/S accounts with at least $50mm in equity and has been rebalanced every 6-12 months to keep sample representative of historical accounts. Alpha calculations reflect alpha generated by the Goldman Sachs VIP Index relative to the S&P 500 TR Index. See www.franklintempletondatasources.com for additional data provider information.

In addition, rising rates have resulted in short rebates turning positive for the first time in over eight years for many managers. We expect this to persist. The Federal Reserve and other central banks have been pumping tremendous liquidity into the system since 2008, compressing spreads globally and really driving risk asset flows. In our view this is poised to end, and when it does, it will be an inflection point in the markets. Just like the Fed, the Bank of England has telegraphed to the market that they are going to pull some liquidity out of the system. We expect the same from the European Central Bank.

Relative Value – Fixed Income

High Yield Market Weight by Yield to Worst

In our view the high yield market has never been more interest rate sensitive. Investors have been lulled into complacency, with the consensus view that rates will stay lower for longer. This is a very different narrative from the thinking when Trump was first elected.

Hedge Fund Long Alpha by Net Exposure

Past performance is not an indicator or a guarantee of future performance.
Source: JPMorgan. High Yield market represented by the JPMorgan High Yield Index. Data as of September 13, 2017. See www.franklintempletondatasources.com for additional data provider information. Indexes are unmanaged and one cannot invest directly in them. They do not reflect any fees, expenses, or sales charges.

While rates have remained low, duration is still a significant and prevalent risk in many fixed income investors’ portfolios. We believe that relative value fixed income managers, such as long/short credit managers, are well positioned to help mitigate this risk given their shorter duration portfolios. We expect these managers should generate alpha from rising sector dispersion as rates rise, which we fully expect.

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 on the Rise

We define global macro CTA as intermediate to long-term systematic investing and trend following. We think it’s an interesting time to be in the strategy because we are just starting to come out of a technical drawdown. In our experience that’s been one of the better entry points to be in the strategy. The BTOP50 Macro/CTA Index has had four sizable drawdowns in its 30-year history, and June 30, 2017 was the bottom of the fifth such drawdown. We view the recovery as already underway, beginning in July and August 2017. The average recovery from the bottom of the prior four major drawdowns was 21.8% over the following 12 months. Of course, past performance cannot guarantee future results.

BTOP 50 Index Drawdowns and VAMI 1987-2017

Merger Arbitrage Spreads Remain Attractive

 

BTOP VAMI

BTOP 50 Drawdown

Past performance is not an indicator or a guarantee of future performance.
Source: Bloomberg.Data from January 1987 to August 2017. See www.franklintempletondatasources.com for additional data provider information. VAMI refers to the Value Added Monthly Index, which tracks the performance of a hypothetical $1,000 investment.

In short the strategies appear to have entered a recovery phase, benefiting from stronger trending markets and an improved correlation environment.

12-MONTH OUTLOOK SUMMARY FOR Q3 2017

  • Neutral
  • Up Trend
  • Down Trend
StrategyConviction SentimentSummary Statement

Long/Short Equity

We maintain a constructive outlook for long/short equity investing, despite maintaining a measured outlook on overall market levels. Even with equity market valuations being near highs, managers continue to find an abundance of opportunities on both sides of their books, and gross exposures remain elevated. Certain trends that have posed a tailwind for long/short equity performance such as stocks reacting to fundamentals, lower stock correlations, and increased stock dispersion all are likely to continue over the next 12 months given that corporate earnings and global economic growth remains robust.

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

Event Driven

Corporate activity is expected to remain robust as companies expect more business friendly policies in the future – less regulation, lower taxes, tax holiday on cash repatriation, and reduced antitrust risk. Despite no concrete progress on reforms, CEO optimism remains at elevated levels. Merger arbitrage spreads remain attractive relative to yields while special situations and activism will be 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

Maintain positive outlook for all three subsectors of global macro strategies. Systematic managers are benefiting from an improved trend following environment and lower cross-asset correlations. A more active central bank calendar should present discretionary managers with potential attractive trading opportunities across both developed and emerging markets.

Long Short Equity: Equity Market Neutral

Certain trends that have posed a tailwind for long/short equity performance such as stocks reacting to fundamentals, lower stock correlations, and increased stock dispersion all are likely to continue.

Relative Value - Fixed Income

The less directional nature of relative value strategies remains attractive amidst the greater uncertainty in the markets, with slightly positive outlooks on convertible arbitrage and volatility arbitrage.

Macro CTA

A more active central bank calendar should present discretionary managers with potential attractive trading opportunities across both developed and emerging markets.

For the complete discussion of our Q4 outlook for each hedge strategy, download 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

Charmaine Chin

Charmaine Chin
Managing Director
Head of Credit, Relative Value, Event Driven

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.