The Complexities of Market Behavior
As we’ve been on the road speaking with clients over the past few weeks, a common theme has emerged – widespread confusion regarding the market’s behavior. Is a strong jobs report good for the market? One would think so, but maybe that leads to higher wages, and thus higher inflation and interest rates that are bad for the market. Why are higher interest rates bad for the market? Maybe because you have to discount future cash flows at a higher rate, leading to a lower present value. But if higher interest rates are an indication of stronger economic growth, and even though you’re discounting at a higher rate, those cash flows will be larger, so it’s a net positive. And what about oil? This week falling oil prices have been blamed for falling markets and credited for rising markets. Throw in the fact that equities have once again been heading higher despite stretched valuations, slowing sales, lower operating margins and thus lower profits, and you’ve got plenty to scratch your head about. What gives?
Even in a more normalized environment (if there is such a thing) it takes a lot of hard work to correctly understand the multi-faceted impact of each release of economic data. But in the artificial, central bank-supported environment that we find ourselves in today, that job becomes increasingly difficult. What we do know is that while fundamentals and valuations are predictive of long-term returns, they are silent as to timing.
So what are investors to do?
We need to acknowledge that we are naturally biased to take action. However, often times being a successful investor means being patient for long periods of time, fighting against the desire to act and waiting for more favorable environments to take more risk. In the meantime, staying broadly diversified by asset class, geography and strategy type is usually the best course of action, coupled with systematic rebalancing. Of course there will be months like October, when full on risk-taking is rewarded, and the natural response is to question the value of asset class diversification or the use of hedged strategies. But that is what is needed over the long term. So stay focused on the end game, view CNBC and Bloomberg as the entertainment that they are, and don’t overthink the endless flow of data or it will wash away your sanity.
Equity markets reversed course in October as the MSCI World Index gained nearly 8%. Given this tailwind, Long/Short Equity outperformed all other alternative categories by a healthy margin, gaining 2.8% for the month, and bringing year-to-date performance to -0.7%. The laggard during the month was the Managed Futures category, which was down just about 2%, leaving the category down roughly the same year-to-date. However, over the last 12 months the Managed Futures category lead all other strategies, with a gain of 4.2%. On a longer term basis, Long/Short Equity continues to outperform all other strategies, earning 5.5% annually over the last three years. Few investors have earned that return though, as there has been wide divergence between top and bottom quartile managers.
Asset flows continue to be directed to Multialternative and Managed Futures funds, which brought in $596 million and $920 million, respectively. These inflows have continued to be fairly concentrated among the largest funds in each category. Flows into Equity Market Neutral and Long/Short Credit were fairly flat, while Long/Short Equity continued to shed assets, losing more than $300 million during the month. While Long/Short Equity has had relatively flat performance year-to-date, some of the largest funds in the category have printed decidedly negative performance in 2015. This has led to significant outflows for the larger funds, and created a negative drag on flows for the entire category.
Liquid Alts in Defined Contribution Plans
Here’s a worthwhile (and short) read on introducing alternatives to defined contribution plans. The punchline: target date portfolios are the most natural way to introduce liquid alternatives into 401(k) plans. We tend to agree and have seen the beginnings of this already. This will likely prove to be a large opportunity for liquid alternative providers in the near future.
Alternatives in the News
Bucking Recent Liquidity Trends
Avenue Capital, a credit-focused hedge fund firm, is bucking recent trends to get more “liquid” with their offerings. They plan on liquidating positions and returning investor capital from their original hedge fund as soon as market conditions allow, with the intention of offering more private equity style structures, with lock-up periods ranging from five to seven years. Such a move lends credibility to the voices of concern over bond market liquidity and the potential mismatch between investment vehicles and their underlying positions.
Oh to Have Such Problems
Why this is newsworthy isn’t clear, but we’ll chalk it up to entertainment value. Ken Griffin, founder and CEO of Citadel, was recently hit with the largest property tax bill in Palm Beach history. He will pay more than $2.2 million in property taxes for his oceanfront estate’s five separate properties. Maybe someday we’ll be lucky enough to have similar problems.
An Important Reminder
While many seem to be relishing in Bill Gross’ underperformance, his recent lackluster returns don’t necessarily indicate that he’s lost his edge or that his strategy has become ineffective. As much as we hate to admit it, luck, or random variation, plays a role in short-term fund performance, just as it does at a blackjack table (even when the odds are stacked heavily in your favor). It is crucial that investors not forget this, lest they engage in the fruitless exercise of constantly chasing the “hot dot”.
Halloween Sugar Play?
Many hedge funds seem to have recently acquired a sweet tooth, as the commodity sector has gained more than 30% since August 24. Several large hedge funds, including Tudor Investment Corp. and DE Shaw & Co., have amassed positions in sugar. Sugar has seen fundamental improvements as annual production has fallen below worldwide use, shrinking a worldwide sugar glut that pushed sugar to seven year lows. If the hedge funds are right, maybe this will provide an opportunity in the dental office market!
As the Fed prepares to raise rates for the first time since 2006, and investors worry about the impact on their portfolios, it’s worth pointing out the potential benefits of rising rates to certain alternative strategies. Over time the return on cash has been an important source of returns for Managed Futures strategies. Why is this? Because the margin requirements for trading futures are quite low, and thus Managed Futures funds sit on substantial amounts of cash. Earning roughly 0% on that cash over the last few years has been decidedly detrimental, especially to real returns, as inflation, while not high, has been well above 0%. Rising short term rates will be welcomed by the Managed Futures community and its investors.
In addition, while not as impactful historically as has been the case for Managed Futures, rising rates should be beneficial to Long/Short Equity strategies as well, because of what is known as the “short rebate”. When a stock is sold short, the borrower has to pay a fee to the lender (and that fee is dependent on the availability of the stock). That fee has typically been below the rate that can be earned on the cash generated from the short sale that is maintained as collateral for the loan. In recent years, with short term interest rates at 0%, there hasn’t even been a return on cash sufficient to offset the cost of borrowing, let alone to add to total return. As rates rise, long/short investors will once again earn the short rebate that has been absent in recent years.
Happy Thanksgiving to All!
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