Hedge fund strategies need to cope with volatility and uncertainty in 2012 markets

Choosing a hedge fund strategy that will perform well in 2012 is difficult. With unprecedented ambiguity about what 2012 will bring, strategies need to cope with market volatility and uncertainty.

What strategy will perform best in 2012?

Tim Berry, Private Advisors
There will be a few value opportunities in 2012. The structured and corporate credit spaces will be extremely interesting going forward. While structured markets have sold off dramatically recently, one can lock in good returns if one can live with whatever volatility that may come from Europe.

The structured credit market in general is the most inefficient part of the credit spectrum, so there are opportunities on both the long and the short side.

However, one has to know what you are getting into as it remains to be seen whether fears about Europe that drove prices down in the past two quarters come to fruition.

There will also be good value to be found in corporate credit. But while the space is easier to trade, it is also not as inefficient a market as the structured credit one. Both asset classes will be subjected to the same fundamental risk.

The open question is whether Europe is going into a recession and if so, if it will impact the US and emerging economies. In addition, if European banks are forced to sell assets technical pressure would mount on credit assets, potentially focused on the structured variety. The latter risk will be temporary.

Global macro will also likely perform well because the opportunity set is currently so rich, from currencies to interest rates.

It is an opportunistic strategy that can take advantage of global imbalances, so long-term it is a very interesting space to be in, but will it play out in 2012 versus 2013? That is hard to say.

Finally, long/short equity is one favourite for 2012. It is the longest-running hedge fund strategy, so one could argue that it is the most proven and it is among the most liquid and simple resulting in less execution and operational risk.

It has been out of favour for such a long time that it is not unreasonable to place some bets on it if you are a contrarian.

Mustafa Jama, Morgan Stanley Alternative Investment Partners
We see an ongoing tug of war between a shaky economic and political backdrop and a relatively healthy and attractively valued corporate sector. This tension warrants a balance between tactical trading and fundamental security selection strategies in 2012.

We anticipate episodes of heightened volatility to provide sufficient trading opportunities for discretionary macro managers. More specifically, we believe divergent central bank policies in emerging versus developed regions are likely to drive opportunities in rates and currency trading. Despite disappointing 2011 results from equity long/short managers, we do not believe capitulation is warranted in light of peaking correlation levels. However, fundamental and quantitative equity funds equipped to monitor and manage factor biases are less likely to be thrown off course by market gyrations. We do not believe a steady and robust event driven opportunity set is consistent with highly volatile markets, but do expect more episodic opportunities in risk arbitrage, similar to 2011.

Within credit we do not see a new distressed cycle forming given the de-leveraging that has occurred in the corporate sector, although Europe warrants close monitoring. We favour the excess spread in credit sensitive mortgage products to high-yield corporate credit. We also believe that prepayment driven strategies in mortgages have the potential to produce continued attractive returns.

Finally, as supported by recent inter-quartile spreads of funds within the same strategy, we believe that manager selection within strategies will equal strategy allocation in importance in 2012.

Andrew Rogers, Gemini Fund Services
The hedge funds that will attract the most interest from investors in 2012 are those that offer transparency, liquidity and non-correlation to the stock market. They must also be registered with the Securities and Exchange Commission (SEC) and other regulators to reduce investor concerns.

Hedge fund investors have been wounded by a series of frauds that damaged confidence in un­registered products. These investors are migrating to registered commodity trading accounts (CTAs) that offer regulation under the US Commodity Futures Trading Commission and potentially the SEC, while providing non-correlated performance to the stock market, frequent liquidity, and transparency. CTAs also provide exposure to commodities investors have been allocating more assets to, such as metals, currencies and food.

Alternative mutual funds will continue to migrate to long/short and other alternative strategies as exchange traded funds (ETFs) expand in directional funds and reduce fees for long only funds.

Successful hedge fund strategies will have to separate themselves from alternative mutual funds and focus on categories that mutual funds are restricted in investing, such as real estate and commodities.

Hedge funds provide efficiencies to the marketplace and the market that is currently the least efficient is real estate. Hedge funds that provide opportunities to profit in the current real estate market may be very successful and assist the real estate sector in regaining its footing.

Scott Schweighauser, Aurora Investment Management
We are significantly increasing our allocation to macro trading strategies. These managers have the flexibility to take advantage of sustained trends in markets, especially as we go through an enormous sea change in the currency, fixed income, government bond markets and commodities markets. We want more of our capital with asset managers that can demonstrate that flexibility and nimbleness.

I think the volatility-based strategies will also do particularly well as we really face a very sustained high level of volatility in all the asset markets, whether equities, bonds, commodities or foreign exchange.

Those strategies that we expect to do less well and face significant headwinds are fundamentally based stock selection strategies like long/short equity. So we are reducing that proportion of capital in our portfolio. We are not eliminating it altogether but we are thinking of a much smaller allocation in the portfolio to recognise the fact that these managers face more significant challenges.

We are also increasing our exposure to credit managers, people who are going to be much higher up in the capital structure and who can identify through their research very attractive situations which have a very favourable risk/return profile.

Dieter Wermuth, Sergey Ilchenko and David Denning, Wermuth Asset Management
We believe that while there used to be as many as three minor financial crises in a decade limited to a few countries, there may now be a higher frequency and more countries and sectors may be engulfed in them. Therefore, we believe the best strategies for 2012 will continue to be those that combine quantiative techniques with daily liquidity and activist value investing with a longer-term horizon.

Quant strategies are able to make money in falling and in rising markets, starting from buy, sell and neutral lists generated by in-house research, with automated execution based on trend-following models, taking away the emotional stress in hugely volatile markets. While such strategies may not be doing well in choppy sideway markets, the outstanding performance when there are strong up or down trends makes up for this.

Second, activist value investing strategies are fundamentally undervalued. Debt-free markets, like Russia, have a potential upside of five to nine growth in price/earning ratios while depressed company earnings may double or triple over the medium term. This could mean that p/e values could go up by a factor of five to nine, while limiting downside as one can buy assets far below book and replacement values and in sectors uncorrelated to commodity prices.

Isaac Souede, Permal
I think it is really a continuation of what we have seen so far in 2011. With uncertainty and volatility very high, we like the macro space right across the spectrum. We like the long and short space in non-US, non-European markets. I also think when you have periods of stress you end up with distress. In distress comes event driven investing, just as we saw at the end of 2008. So that is the last strategy we are favouring right now.

Kurt Silberstein, Ascent Private Capital Management of US Bank
Selecting the best-performing investment strategies during a period of heightened political and financial uncertainty is quite challenging. Although the opportunities are abundant, the return to risk tradeoff is skewed to the downside.

We view 2012 as a year to remain cautious and begin to construct a hedge fund portfolio that will benefit from a more favourable market environment in 2013/14. In the short term (2012), financial and political uncertainty will likely exist. So we are more comfortable allocating capital to non-directional strategies that have a higher probability of generating absolute returns and protecting capital during periods when the public markets are very choppy. We do not believe the returns outweigh the risks of investing in the more directional strategies in this market. Although getting it right in this market can lead to big returns, the opposite result can just as easily occur.

Looking beyond 2012, we see the market favouring event driven strategies. This view is based on the current backlog of IPOs and the amount of cash on the corporate balance sheets of the large global companies. In a low-growth environment, it is expected these companies will use the cash on acquisitions to realise higher returns on capital that can be realised in a shorter time frame rather than invest it internally and try to grow the business organically.

We also expect fundamental long/short equity to perform well once the market begins to focus more on valuations and less on emotions (fear/greed).

Daniel James, Aviva Investors
In a world of radical changes, with eurozone debt downgrades and fast-moving markets, it is increasingly difficult to select the best strategies to suit your investment needs. For example, you may be finding it difficult to diversify your portfolio effectively using the traditional fixed income strategies as a result of increased market volatility causing returns from many asset classes to be more correlated than usual.

Historically, institutional investors have viewed fixed income as a choice between sovereign and credit risk. However, there is a variety of other asset classes to extract performance from and today’s challenging markets have resulted in this perception changing. As a result we believe that on a very fundamental level there is now a need to focus on a strategy that will not just work in the fixed income world of today but also in the future.

At a time when the outlook for most asset classes suggests that returns will be lower than those which investors have come to expect and with investment cycles shorter and more volatile, we believe a strategy that broadens its return sources and seeks an intelligent coordinated approached to risk budgeting will do well in 2012.

This strategy is achievable by building a global fixed income portfolio that combines beta with many different sources of alpha and that manages risk in a dynamic way, positioning a portfolio in such a way that it can successfully navigate its way through prevailing market conditions.

It is possible to combine various sources of alpha by bringing together the best investment ideas that are generated by individual fixed income teams across areas such as emerging markets, credit and sovereign. By combining these multiple independent return sources into a globally diversified fixed income portfolio, it provides the potential to achieve better risk-adjusted returns than through being directionally long or short the underlying fixed income asset classes. This type of strategy offers diversification across uncorrelated investment teams and classes and can provide consistent and regular fixed income returns through an effectively diversified fixed income approach.

With financial markets changing rapidly, it is now more important to ensure a strategy will work well in all conditions. A global diversified fixed income strategy not only achieves diversification on an asset class but also on a country level. This will position investors well for the oncoming events of 2012 and beyond.

Macro strategy favoured by most managers

A majority of hedge fund managers (57%) believe macro factors will be the main drivers of performance this year, according to the 2012 hedge fund manager survey by Aksia.

However, there were disparate responses between long/short equity and tactical trading managers. Those following a long/short equity strategy disagree with the consensus view, with 67% saying fundamentals will lead in 2012, while tactical trading managers voiced the strongest opinion for macro performance drivers, with 90% in favour.

Overall, respondents’ first choice for the strategy most likely to perform best in 2012 was tactical trading followed by event driven, relative value and long/short equity.

Within sub-strategies the strategies that received the most votes as likely to perform best this year were global macro in first position followed by long/short equity (all), event driven debt, event driven equity and long/short credit.

Of the 125 managers that responded to the survey, 38% were categorised as long/short equity, 26% as event driven, 18% as relative value and 18% as tactical trading.