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Cape Town - In 2016 markets were taken by surprise by a number of big-ticket events such as the Brexit and Donald Trump becoming the new US president-elect.
A steep learning curve for market participants has been the unpredictability of the outcome of national polls – as most placed their bets on the losing side of both the latter events.
Against this background Nosibusiso Ngqondoyi, head of research at Novare Investments, provides an overview of the hedge fund industry in 2016.
Performance
Global equity markets recorded the worst start to a year in history as investors panicked over the uncontrollable drop in oil prices, concerns over China’s economic growth and expectations of sluggish global growth. This increased the demand for the safety of high-quality bonds which subsequently led to prices skyrocketing and causing trillions of dollars’ worth of bonds to yield negative returns.
Against the backdrop of a low equity return environment, hedge funds, which offer a diversified source of alpha, were best positioned to take advantage of this convergence of circumstances.
According to Hedge Fund Intelligence, global hedge funds have been successful at protecting capital - delivering an average return of 0.7% in October year-to-date (YTD) and seven out of ten hedge fund strategies delivered positive returns. In comparison, global equity returned 1.7% as measured by the global equity index (MSCI World), over the same period.
Looking at regional performance, hedge fund managers in the US posted the best average return over the period at 3.8%, this was slightly behind the local equity market return of 4.0% as measured by the S&P 500 index - with all strategies posting positive returns and six out of nine posting returns in excess of 3%.
European hedge funds delivered an average return of 1.62% with emerging market equities and fixed income strategies logging the best performance. Hedge funds with emerging market exposure were well-supported by the recovery in oil and commodity prices during the second and third quarter of the year.
Asian Pacific hedge funds delivered an average return of 2.4% with only the Japan long/short strategy in the red.
Local hedge fund returns followed a similar pattern with fixed income contributing notably to returns with an average return of 9%, while the equity long/short strategy was down 2.6% October YTD. This is a stark contrast when compared to 2015 figures when the equity long/short strategy was the best performing strategy, producing an average return of 17%.
AUM & flows
Uncertainty may have been the order of the day but this didn’t stop the global hedge fund industry to grow to a record level of $3trn, mostly due to good returns (according to the HFR Q316 Report). This was despite continued outflows to the tune of $51bn YTD to September 2016. Ironically, the majority of these outflows were experienced in well-established hedge funds that tend to have large exposure to liquid large cap stocks.
In the graph below, the South African volatility index (in green), which gauges the level of fear in the market, and the ALSI 40 (in red) the top 40 shares on the local stock market, move in opposite directions - meaning the two are negatively correlated. When there is increased fear in the market, the green line goes up and the red line down.
During these periods the top 40 shares, known as large-cap stocks, tend to underperform as they get dumped. The investors that own them subsequently lose money and vice versa.
Smaller hedge funds have proven to be more resilient during periods of increased market fear and are better placed to take advantage of short-term market opportunities due to the ability to be agile and nimble. The emerging market hedge fund industry also ended the third quarter on a new high with assets under management just short of $200bn largely due to strong performance (+5%), in spite of experiencing outflows of $850m.
The trend was no different locally and the South African hedge fund industry saw assets under management rise to R68.5bn mostly due to solid returns (this is according to the latest Novare Hedge Fund Survey findings covering the 12 months’ period ending June 2016). Contradictory to the global market, the local industry experienced little (if any) outflows during the measurement period.
It was also during 2016 that the local hedge fund industry saw the launch of its first regulated South African Retail hedge fund under the Collective Investment Schemes Control Act. With the introduction of the new regulation, hedge funds could gain access the South African retail market which has more than R3trn in assets under management.
Strategy review
Equity long/short strategies and strategies that take a directional view (as opposed to strategies that take a neutral view on the market) had a disappointing year. During the first half of the year, portfolio managers had no faith in the direction of the market.
It can be said that the big market swings since the start of the year, predominantly driven by macro factors as opposed to market-related drivers, contributed to this. Despite the fact that periods of uncertainty are generally good for hedge funds (as it presents trading opportunities), the exaggerated and prominent daily swings experienced did not bode well and made it difficult for managers to profit from falling share prices, as prices moved too rapidly.
Most hedge fund managers were positioned fairly negative going into 2016 and had a lot of protection in their portfolios. Most had a negative view on the resources sector, motivated by global growth concerns, particularly in the US and China.
Ironically, the big bounce back for the year came from the Resources which delivered 34% YTD while financials were flat at 0.3% and industrials down 10.1%. Most equity long/short managers that had a high exposure to stocks that benefitted from the weakening rand performed exceptionally well last year, however, YTD this strategy hindered performance. This was mostly due to the rand strengthening by 9% to the US dollar.
The equity long/short strategy was not the best-placed strategy to be exposed to this year. In response to this, investors and asset allocators globally diversified away from the equity long/short strategy and re-allocated to funds with little-to-no active bets on the market.
The market neutral strategy benefitted most from this movement as well as the wide price dispersion in the market as a result of increased fear in markets. There were also increased allocations to multi-strategy and fixed Income hedge funds which benefitted from the massive drop in bond yields globally as the search for safe haven assets intensified.
Conclusion
Ngqondoyi says it has been a challenging year for markets and hedge funds were not immune. While some strategies experienced negative returns, hedge funds have managed to protect capital and generate returns at lower risk.
"In the year ahead sluggish global growth will remain a challenge and will most probably have a knock-on effect on return expectations," says Ngqondoyi.
"Hedge funds, however, remain better placed to deliver absolute returns to investors as they can make money in rising and falling markets, unlike traditional investments, which largely rely on rising stock markets to post positive returns.
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