Third Quarter Hedge-Fund Strategy Outlook: K2 Advisors

K2 Advisors seeks to add value through active portfolio management, tactical allocation and diversification across four main hedge strategies: long short equity, relative value, global macro and event driven. In their third-quarter (Q3) 2017 outlook, K2 Advisors’ Research and Portfolio Construction teams share the key market events they have an eye on, along with the select strategies that represent their “top convictions.” We believe offering these insights will help investors better understand the rationale for owning retail mutual funds that invest in hedge strategies.

As we move into the third quarter we find our attention focused on the actions of the US Federal Reserve (Fed). The Fed has now raised interest rates four times as part of an apparent normalization of monetary policy that began in December 2015. From an investment perspective, we view the Fed’s decision to move interest rates higher as a positive one, particularly as it pertains to a divergence between US 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 help create fertile opportunities for active hedge-fund strategies to capture alpha-centric1 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. what the best course of action may be.

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 US 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 even as the labor market is tightening.”

So, the data do 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.