Global Investment Report’s 2022 Annual Hedge Fund Survey: Mid-Year Update
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A First Half of Historic Divergence
The top 50 broad strategy funds – determined by highest historical performance through 2021--outperformed the market by 21 percentage points through the first six months of 2022
Summary: July brought some relief: a market rally, a soaring jobs report, and inflation numbers that didn’t accelerate as commodity prices continued their decline. This may suggest to some investors we’re past the worst of the bear market. But inflation remains stubbornly high, rising interest rates are threatening recession, food and energy insecurity are growing more acute, and serious supply chain issues remain. Somewhat forgotten: The tragic six-month Russian war against Ukraine shows no signs of letting up, exacerbating macroeconomic and security problems and raising geopolitical tensions. All of this has contributed to one of the market's worst first-half starts since the Great Depression. More remarkable that the Top 50 Hedge Funds ended the first half of 2022 in the black, outpacing the market by 21 percentage points.
Source of outperformance: Multistrategy, volatility arbitrage, and global macro funds propelled the Top 50 into positive territory while the market collapsed.
A recent Financial Times headline exclaimed, “Investors Grow Frustrated with Hedge Funds after Historic Losses.” The story’s lede: “Hedge funds are heading for one of their worst years of performance on record.”
A number of celebrated funds are making a mess of things. According to the FT, Daniel Loeb’s Third Point fund declined 20%, Lee Ainslie’s Maverick Capital was down 35%, and Chase Coleman’s Tiger Global can’t seem to get out of its own way, having lost half its value during the year’s first six months.
But the article was not seeing the whole picture.
The financial media’s penchant for hedge fund schadenfreude is a key reason behind this survey’s perennial look at pockets across the industry that merit attention.
The BarclayHedge hedge fund index for the first half of 2022 reported average returns of -9.6%. That’s much better than the S&P 500’s decline of 20%--the benchmark’s worst first-half performance since 1970. Even more compelling: the industry’s bellwether strategy--equity long/short--declined by just -3.5%. This echoes what happened the last time stocks plunged. The S&P was down -37% in 2008 while equity long/ short funds lost less than -12%.
The Top 50 funds identified in this year’s annual hedge fund survey-- comprised of the strongest long-term performing broad-strategy funds through 2021-- collectively outpaced the market during the first six months of 2022 by 21 percentage points. This built upon the 50’s seven-plus percentage point edge over the S&P 500 after the first quarter.
“Considering the constellation of hedge funds this survey assembled according to a rules-based methodology and long-term historical analysis,” observes Ben Crawford, head of research at a leading hedge fund database BarclayHedge (which has been tracking funds independently for 37 years), “I think it’s remarkable just how well this group has performed during such a sharp downturn.”
While no one has any idea what the rest of 2022 holds, Crawford contends the data suggests something clear and compelling about hedge fund selection: long-term consistency is key. “Finding persistently positive track records with low to moderate volatility through multiple market cycles may represent an underappreciated edge in shaping a compelling portfolio of funds,” Crawford explains.
The survey’s findings suggest a compelling link--even symmetry--between consistent returns and the ability to control downside exposure. This screening still captures outliers whose strong long-term performance comes with more risk. But the group collectively delivered returns well beyond expectations. Emblematic of market agnostic consistency is the volatility fund Dynamic Alpha, which ranked 17th in the survey.
While many allocators doubt the efficacy of this strategy, John O’Brien, a fund director at Dynamic Alpha, says positive performance during the first half of the year was based on a commitment to process that doesn’t seek to exploit trends to maximize profits. This would increase risk. He says, “in June, when volatility was high and the market fell, we increased hedging, tightened spreads and reduced overall exposure to increase efficiency during the selloff. This benefitted the portfolio in July as the market rallied and volatility fell, and we then normalized trading parameters.”
First-half 2022 was the fund’s first bear market. Still, it outpaced the S&P 500 by 24 percentage points--a wider degree than it has ever done in a calendar half year since its launch in May 2016.
The Top 50 significantly outperformed the market despite the substantial hit suffered by several of its hedged equity funds. But these loses were offset by 10 multi-strategy funds that gained an average of 5.3%, 3 volatility arbitrage funds that returned 8.5%, and 5 global macro funds that soared an average of 46%. All told through June, the Top 50 was in the black, having gained 0.73%.
A wide range of strategies and management styles accounted for the group’s expansive dispersion. With 15 hedged equity funds accounting for the largest number of funds in the 50, their performance ranged from +15% to -40%. Their average return was down -15% --virtually the same as the BarclayHedge Equity Long Bias average. But it was much worse than the database’s Equity Long/ Short Index, which lost less than -3.5%.
The poorest equity performers were Old Kings Capital (-40.1%), followed by North Peak Capital (-37.7%), Skye Global (-35.4%), and Legion Partners (-32.2%).
The best-performing hedged equity funds were MAK One (+15.3%), Citadel Tactical (+12.6%), and Schonfeld Fundamental Equity (+2.9%).
Two well-known multistrategy managers, Citadel Wellington (+17.5%) and D.E. Shaw (+16.9%), helped this group outpace the BarclayHedge Multistrategy index by nearly 10 percentage points.
The 50’s global macro funds received a seismic boost from Haidar-Jupiter, which soared 170% through the first half of the year. John Street Capital climbed nearly 28%. These funds propelled the group far past the BarclayHedge Global Macro index returns of 4.99%.
Some noteworthy returns outside of these three strategies include Whitehaven’s Credit Opportunities, which relies on fixed-income relative value trades of US municipal debt. It weathered the rising interest rate environment, ending the first half of the year slightly up, +0.85%.
Three managers that appeared vulnerable to rising interest rates and related stress did quite well. Opportunistic junk debt specialists Millstreet Capital gained nearly 3% and Arena added more than 5%. And in spite of the losses suffered across emerging markets, equity manager Waha MENA tacked on nearly 8%.
On the downside, merger specialist Ramius declined -13.3%. And concerns this report initially expressed about how a rising interest rate cycle may hit the intriguing Enko Africa Debt fund came to roost with the fund having declined -23% during the first half of the year.
“There’s plenty of risk ahead,” says Ken Tropin, founder and chairman of Graham Capital Management, which manages $18 billion. While he believes inflation has peaked, he sees structural and cyclical forces keeping inflation well above the Fed’s target and forcing the central bank to remain aggressive.
In contrast with observers who are expecting a return to the previous status quo, Tropin sees “a new paradigm evolving that’s less favorable for risk assets “characterized by heightened market volatility and uncertainty.” Further, he thinks there’s not much chance the economy and markets will return to the previous decade when fund outperformance over risk-free returns had nearly tripled historical spreads. “I believe the 12 years following the financial crisis in 2008 of easy global monetary policy and a perpetual bull market was abnormal,” says Tropin.
This shift may be evident with the Fed having pushed up overnight rates in July for a second consecutive time by 75 basis points to 2.25%- 2.50%. And there’s a good chance for another such rise in September. Federal Reserve Bank Chair Jerome Powell said future moves would be geared to what the data is telling the central bank. “As the stance of monetary policy tightens further,” he explains, “it likely will become appropriate to slow the pace of increases.” Still, Powell wants to ease growth to help enable the supply side to catch up.
Long-term investment strategist Edward Yardeni argues de facto interest rates have actually moved even higher than what current overnight rates are telling us. That’s due to the impact of a rallying dollar that has appreciated by more than 10% this year (increasing the price of US exports but cutting the cost of imports) and the Fed’s shift to quantitative tightening that has pushed $150 billion off of its balance sheet. Yardeni thinks these two factors have effectively increased interest rates by at least another 100 basis points. And that shift will get an even bigger boost, he says, starting in September when the Fed accelerates QT by more than a factor of three. By August 2023, an additional $1.1 trillion will have run-off the Fed’s book.
Whether or not that means there’s greater downward pressure on rising prices, noted Danish economist Lars Christensen believes it will take more than 2 years before inflation returns to pre-crisis levels. (https://www.globalinvestmentreport.net/wp-content/uploads/2022/05/Linked-In-Post-of-Lars-1.pdf) Given that prospect, he’s concerned the Fed might ease its inflation tolerance, even targeting levels of 4%, to allow it to cut rates sooner to boost growth.
While the US economy has contracted for two straight quarters, Europe surprised many economists with 2nd quarter GDP having surged 4% from the year earlier. This followed a 1st quarter gain of 0.7%. The Russian invasion of Ukraine hitting the continent along multiple fronts, along with a steadily weakening euro that’s sending energy and import prices higher, led many observers to project much weaker numbers.
The financial consultancy, Deloitte, ebulliently reported, “the Eurozone economy was in excellent shape. This was likely due, in part, to strong consumer demand for tourist services. With the pandemic receding and the dollar strengthening, people were eager to return to their previous love of travel. This was reflected in strong growth in France, Italy, and Spain – significant tourist destinations.”
Positive growth numbers may have made it a bit easier for the European Central Bank to U-turn away from its previously cautious monetary posture and raise rates 50 basis points in late July to more aggressively counter persistent inflation.
However, growth stalled in the continent’s largest economy, Germany, which was unchanged from the previous quarter, but still up 1.5% from a year earlier. And this is fueling extremely negative German investor sentiment, which threatens European growth.
This forward-looking gauge is revisiting levels not seen since the eurozone debt crisis more than a decade ago. This collapse is directly related to the Russian invasion of Ukraine and NATOs sanctions that followed. Investors fear the potential collapse in access to Russian natural gas and soaring energy prices, continued supply chain issues, weather-related shocks, and mandated cuts in energy usage will further slow the country’s and eurozone’s growth.
What does all this mean?
According to Thomas Hempell, head of macro and market research at the €585 billion asset manager Generali Investments, central banks’ rush to tame inflation is being increasingly complicated by growing energy crisis and political uncertainties.
While he agrees central banks need to move away from accommodative interest rates to reclaim their inflation-fighting credentials, he warns risks are tilted towards an even more toxic stagflation dilemma if the energy crunch in Europe deepens as Putin punishes the continent for sanctions it has imposed on Russia. For Hempell, the combination of surging natural gas prices in Europe, rising inflation and interest rates along with continued supply disruptions are reducing growth forecasts and increasing recession risks over the next year. He projects eurozone growth to come in at less than 1% in 2023.
The world did receive some good news out of Ukraine with the agreement that’s restarting the shipping of Ukrainian grain and Russian fertilizer through the Black Sea. This activity had been shut down since March, pushing up food prices and intensifying the threat of famine throughout much of the Third World.
But offsetting this positive development was the intensification of the conflict in eastern Ukraine. Lars Christensen sees the Russification of parts of this region as tragic and genocidal.
Further, the war’s now encircling the continent’s largest nuclear power plant in Zaporizhzhia. Russian forces have set up artillery units within the complex to shell targets across the region while interfering with worker access to the plant that’s compromising operational safety of the site’s multiple reactors.
Speculation about why Moscow is doing this ranges from its plans to shut off power to 20% of Ukrainians to intentionally causing a radiation event – a very big dirty bomb. This is adding a whole new element of uncertainty to a continent already beset with a myriad of worry.
Christensen’s biggest concern is the war reflects “the reversal in the trends of global checks and balances that has largely kept the peace over the past several decades. This can unleash all sorts of uncertainty, including the ratcheting up of tensions between China and Taiwan.”
While many European allocators are increasing their weighting to the US, it’s not without significant risk. While he agrees America is less exposed to energy supply shocks, Generali’s Hempell anticipates the slowdown in US manufacturing spilling over to the rest of the American economy. “US 2023 growth rate may also come in below 1% as the risk of a recession nears 50%,” says Hempell.
In spite of the summer rally, it’s hard to make an argument that we’re closer to the end than the beginning of this period of economic and geopolitical distress.
Cedric Dingens, head of alternatives at the NS Partners with CHF10.5 billion under management, thinks the recent equity rebound could be just a bear market rally. He’s taking advantage of the recent surge in prices by “gradually taking some profits from his directional equity funds.”
He’s becoming increasingly more defensive, combining significant macro exposure with multi-strategy funds and higher cash levels to help counter a market correction. At the same time, he’s holding onto his equity long/short managers to exploit idiosyncratic opportunities that evolve during especially volatile markets.
After benefitting from trend followers’ very good first half, he cautions that, “it’s usually not the best time to allocate to CTAs and Quants after they just had a fantastic run.”
Ken Tropin believes traditional assets will remain vulnerable as “the Fed will no longer provide a tailwind for beta strategies, and bonds also look unattractive given high inflation and the prospect for higher rates.”
Despite the first-half decline, Tropin doesn’t think a recession is priced into the market, especially given the subsequent rally. “I think the selloff was a very normal correction after years of a bull market,” says Tropin. “What we’re seeing is the battle between those that buy on the dips and more cautious investors who are far from certain we’ve seen the worst of what all the current geopolitical and macroeconomic problems are throwing at us. I can see stocks falling again from here.” He thinks US overnight rates will end the year between 3.50% and 3.75%, with 10-Year Treasury yields hovering around the same levels. Trailing 12-month inflation will decline to 6.5% to 7.5%. He estimates the greenback will continue to rally with euro-dollar potentially reaching $0.90 and dollar-yen hitting ¥140.
Tropin expects the mid-summer risk-on sentiment to fade with the S&P ending the year 5% to 10% lower than where it was in mid-August. And he expects the recent rise in the US High-Yield Corporate Bond index to be short lived, turning south by about the same degree as stocks.
All of this reinforces Tropin’s belief that we’re in among the most compelling macro investing environments he’s seen in a while.
Graham’s Proprietary Matrix fund, which combines quantitative and discretionary macro trading strategies, was up 26.49% during the first half of the year. Key profit drivers, according to Tropin, included long energy positions, short positions in the short-end of US and European fixed income markets as well as in the long-end of U.S. fixed income. The fund also gained from being long the U.S. dollar versus a variety of G10 currencies as well as being short European, U.S., and Asian equity indices.
Given the steady selloff in high-yield across the first half of the year, Jeff Growney, partner at Millstreet Credit (No. 8) was a bit surprised by the sudden rebound in junk bonds. “We currently don’t think economic data support this shift in sentiment,” he explains.
The sub-investment grade debt fund maintained its low net exposure of 58% through June. Its sustained focus on first-lien debt supported by hard assets, receivables, short duration, and avoidance of covenant-lite paper helped Millstreet end the first half up nearly 3%.
Source: S&P / Dow Jones Indices
The Fed is faced with a tough balancing act, says Growney. With the central bank forced to play catchup, he believes, “this will likely cause material volatility for near-term asset prices. The chances of a miscalculation remain elevated, and we could end up with stagflation or a material recession as this plays out.”
Patrick Ghali, head of the hedge fund consultancy Sussex Partners agrees. He says, “we’re not in a good place right now,” and expects rising inflation, interest rates, and growing geopolitical turmoil will be around for another 18 months. He further cautions, “we haven’t yet seen serious cracks in real estate, and if they were to occur, it would alter the entire economic landscape.”
Accordingly, he believes it’s prudent to be defensive and diversified with low net exposure. That includes reliance on macro, market neutral, convertible arbitrage, and multistrategy funds. Yet, he’s also intrigued by the differentiated opportunities evolving across China and Japan.
But to Lars Christensen, China is his largest concern. He thinks rising tensions over Taiwan is meant to distract from the country lumbering into stagnant growth in the coming years. He believes Beijing’s policies may push China’s economy “into a full-blown financial crisis, which will come with political and social fallout.”
Matt Hu, chief investment officer of the 16th-ranked FengHe Asia fund, which was down -6.7% during the first half of the year, is struggling to see opportunities. “We have been in a cautious state for the past (several) months given the developing uncertainties around us,” Hu explains. But he does say the “current global recession fears and volatile market sentiment will provide precious contrarian investment opportunities for us in Taiwan, Japan and Korea.”
Back in the states, with equity valuations still above historical levels, Night Owl (No. 5) PM John Kim believes “higher-than-expected rate hikes could cause valuation multiples to decrease even further.” In the second quarter alone, S&P 500 PE multiples fell 18%. In spite of having turned half the book into cash, his fund lost -18.6% during the first half of the year.
With the Fed maintaining its hawkish monetary stance, Kim believes this is “decreasing the risk inflation spirals out of control.” He’s not certain about a potential recession or its severity. But he admits the central bank hasn’t ever engineered a soft landing following high levels of inflation. But in seeing significant consumer savings and strong corporate balance sheets, he believes “there’s a chance the Fed may thread the needle.”
With earnings expectations still high, he is maintaining the fund’s substantial cash levels, needing to see a greater decline in earnings projections or valuation multiples before redeploying cash. ■
Source: Generali Investments
About the Author: Eric Uhlfelder has prepared 19 annual hedge fund surveys for Barron’s, The Financial Times, The Wall Street Journal, and SALT. He covers global capital markets from New York over the past 30 years for various major financial publications. He wrote the first book on the advent of the euro post currency unification, “Investing in The New Europe,” for Bloomberg Press. And he has earned a National Press Club Award. His website is www.globalinvestmentreport.net or you can write to him at [email protected]