Hedge Funds Make Do With Challenging Market Conditions

By: Amundi Institute

Highly challenging market conditions for beta as well as for alpha. Central bankers are caught between bad inflation (driven by supply-shocks and by the massive monetary and fiscal stimulus deployed during the pandemic) and recession prospects. They still struggle to sort out the lesser of these two evils. High uncertainty regarding central banks’ decisions, the magnitude of the world economic slowdown, the severity of the EU energy crisis, and the turn in Chinese real estate issues are all limiting managers’ risk budgets and/or making them vulnerable to positioning mistakes. Unsurprisingly, a majority of market segments display contrarian behaviors, making buy-and-hold and momentum strategies vulnerable to frequent asset rotations.

Sentiment indicators are bearish, suggesting investors are well aware of these risks. Yet, positioning indicators, which are rather neutral, tell a different story, emphasizing there is still hope (and therefore risk). In particular, bond investors are still fighting the Fed and do not believe its policy will turn as restrictive as planned. Inflation markets are already pricing a normalization. Equity analysts may still have unfinished business with downward EPS revisions. While asset valuations overall improved, the majority do not offer any more spectacular discounts since the summer rally.

This absence of capitulation is preventing managers from building portfolios on a solid ground, keeping them focused on risk management, which is an increasingly challenging task. The equity/bond correlation is firming but the relationship remains unstable, while the re-correlation across assets adds another hurdle. Also, hedging costs for a majority of assets are not yet particularly cheap and/or reliable. The dominance of transversal macro factors is narrowing the leeway to express thematic views, illustrated by the elevated correlations across our proprietary thematic baskets. As a result, position crowdedness remains a concern (albeit easing). Furthermore, asset prices do not optimally reflect yet their underlying fundamentals changes, a challenge for fundamental and value investors. Finally, the pause in corporate activity and reduced flows in equity, bond and structured primary markets are adding to the current lack of market catalysts.

Nonetheless, hedge funds continue to outperform traditional assets and generate modest alpha. In response to these trying times, a majority of hedge funds have greatly reduced their exposures and leverage. This move began early in 2022, accelerated in March, and was completed over the summer (L/S Credit, and to some extent Merger Arb., were the two exceptions in this broad de-risking). Thus, market timing has been a key source of excess return.

Equities not yet tracking the plunge in liquidity

Originally Published September 14, 2022

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