Global Alternative Investments

Discussion of global alternative investments market action and what it may mean for investors.

September 2016

Adam Taback, Head of Global Alternative Investments

James Sweetman, Sr. Global Alternative Investment Strategist

Justin Lenarcic, Global Alternative Investment Strategist

Spread Compression Again Benefits Event Driven

  • Hedge fund returns were positive in August, outperforming global equities and credit, but underperforming global fixed income.
  • Systematic Macro strategies struggled amid trend reversals in fixed income and commodity positions.
  • We maintain a tactical Overweight recommendation for Relative Value and Equity Hedge, an Even Weight for Macro, and a tactical Underweight recommendation for Event Driven.

Performance estimates from Hedge Fund Research (HFR) indicate a sixth consecutive month of positive performance for the industry. Both value and growth oriented Equity Hedge managers provided healthy gains as active management showed value during a very range bound month. Event Driven managers had another strong month as core special situation positions were additive to performance and included continued positive market reception of certain announced deals/acquisitions, and positive earnings surprises. Distressed managers continued their period of strong performance as spreads continued to tighten in the credit markets. Within Relative Value, the Structured Credit strategy continued to recover first quarter losses as these markets’ attractive underlying fundamentals and yields have been steadily recognized by market participants with higher, more supportive trading volumes. Partially offsetting gains was a particularly difficult month for the Systematic Macro strategy as losses stemmed from long fixed income, Japanese Yen, precious metals, and short energy positions. As markets stabilized and volatility remained low, government bond yields steadily increased, the Japanese Yen abruptly weakened, precious metals’ uptrend receded, and oil bounced off recent lows.

Market Observations

Net exposures and cyclical vs. defensive ratios for Equity Hedge managers remained near YTD highs through August, indicating that many managers remain constructive on the equity markets. Month over month, notable exposure shifts included decreased net exposure to utilities and sizable short covering among communications stocks. The combination of the CBOE Volatility Index® (VIX®) (a key measure of market expectations of near- term volatility conveyed by S&P 500 stock index option prices) at YTD lows, stock dispersion above historical averages, and earnings season helped fundamental stock pickers generate alpha in an overall range bound equity market. In addition to improved trading volume within Structured Credit, August was the first time since February that delinquency rates fell within US Commercial Mortgage Backed Securities, and still remain materially lower than they were one year ago (Source: Trepp). More tactical long-short credit managers could also be presented with opportunities on the short side among weaker credits at this point in the credit cycle.

Global Alternative Investment Perspective

With spreads tightening in recent months, credit dispersion within the corporate and securitized sectors has lessened. However, we still believe dispersion remains favorable for Relative Value strategies, along with strong fundamental metrics and attractive entry points remaining. We therefore maintain our tactical overweight outlook.

We maintain an even weight recommendation for Macro, largely due to uncertainties around global monetary policy and the implications for asset trends, potentially resulting in short-term tail risks that could whipsaw the Systematic Macro strategy. Certain Discretionary Macro managers that are both more nimble and tactical could navigate such an environment more favorably.

We maintain our underweight recommendation for Event Driven strategies, but see an improving opportunity set for both Distressed Debt and Merger Arbitrage over the medium term. Global transaction volume remains lower on a year-over-year basis. However, deal spreads are at more attractive levels than they were last year. This has led to improved performance among certain Merger Arbitrage managers. Regarding Distressed, expectations are for a gradual increase in default rates, fallen angels, and other credit events that can provide potentially attractive opportunities for Distressed Debt managers later this year and into 2017.

We continue to view Equity Hedge (specifically less directional strategies with low-net equity exposure, defined as 20– 35 percent net long) as a high-conviction strategy in this environment. Our conviction is not so much a reflection of our belief in the likelihood of significant outperformance, but our belief that the Equity Hedge strategy accentuates our outlook on being cautious but constructive on the equity markets while reducing risk.

We remain even weight on Private Capital. Within Private Equity, we remain cautious about Large Cap Buyout and late-stage Venture Capital strategies. Instead, we favor obtaining Large Cap Buyout and Venture Capital exposure via Secondary and more niche funds. In Private Debt, we see Europe as more attractive than the U.S. for Distressed and Direct Lending strategies, as Europe’s economic recovery continues to lag that of the U.S.

We maintain an even weight recommendation for Private Real Estate. We expect the low rate environment, stable and modest economic growth, and strong recent returns to continue driving capital into private real estate.

Rationale for Recommended Tactical Tilts – As of 9/1/2016

Asset Class - Hedge: Relative Value
Weight Rationale and Further Detail
Asset Class - Hedge: Relative Value

Overweight

Structured Credit fundamentals remain supportive, although we remain cognizant that trends in property prices and delinquencies have recently softened marginally. Price volatility for structured credit could increase in the coming months, especially as regulatory rules take effect. This volatility may lead to mark-to-market losses, but could also result in attractive entry points.

Asset Class - Hedge: Macro
Weight Rationale and Further Detail
Asset Class - Hedge: Macro

Even Weight

We anticipate choppy trading conditions for the rest of Q3 and into Q4, especially within currency and equity markets. These conditions can limit the effectiveness of Systematic Macro with abrupt trend reversals that can whipsaw trend following strategies as we have seen numerous times this year.

Asset Class - Hedge: Event Driven
Weight Rationale and Further Detail
Asset Class - Hedge: Event Driven

Underweight

Higher beta, equity-oriented sub-strategies like Activist could face headwinds with macro uncertainties and market volatility. Distressed debt managers expect opportunities within asset-based sectors where pricing power will decline and where there is significant leverage.

Asset Class - Hedge: Equity Hedge
Weight Rationale and Further Detail
Asset Class - Hedge: Equity Hedge

Overweight

We still believe this is a stock picker’s environment. However, low-net equity exposure is preferred over more directional exposure. We continue to evaluate our outlook given the difficulties experienced over the first half of the year.

Asset Class - Private Capital
Weight Rationale and Further Detail
Asset Class - Private Capital

Even Weight

Small- and Mid-Cap buyout and other niche Private Equity opportunities are compelling, especially those focused on severe dislocations across industries and geographies. Within Private Debt, we are most constructive on international Distressed/Special Situation strategies.

Asset Class - Private Real Estate
Weight Rationale and Further Detail
Asset Class - Private Real Estate

Even Weight

We prefer Opportunistic Real Estate strategies that can target distressed capital structures. Value-Add investors can benefit from strong demand in core markets by developing and/or leasing properties to sell into core markets (Value-Add real estate investors acquire properties that require improvements and seek to raise the properties’ cash flow by making enhancements to them).

Alternative investments carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. They are complex investment vehicles which generally have high costs and substantial risks. The high expenses often associated with these investments must be offset by trading profits and other income. They tend to be more volatile than other types of investments and present an increased risk of investment loss. There may also be a lack of transparency as to the underlying assets. Alternative investments are subject to fewer regulatory requirements than mutual funds and other registered investment company products and thus may offer investors fewer legal protections than they would have with more traditional investments. Additionally, there may be no secondary market for alternative investment interests and transferability may be limited or even prohibited. Other risks may apply as well, depending on the specific investment product. Please carefully review the prospectus, private placement memorandum or other offering documents for complete information regarding terms, including all applicable fees, as well as risks and other factors you should consider before investing.

Hedge funds are complex, speculative investment vehicles and are not suitable for all investors. They are generally open to qualified investors only and carry high costs, substantial risks, and may be highly volatile. There is often limited (or even non-existent) liquidity and a lack of transparency regarding the underlying assets. They do not represent a complete investment program. The investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Hedge funds are not required to provide investors with periodic pricing or valuation and are not subject to the same regulatory requirements as mutual funds. Investing in hedge funds may also involve tax consequences. Investors should speak to their tax advisor before investing. Investors in funds of hedge funds will incur asset-based fees and expenses at the fund level and indirect fees, expenses and asset based compensation of investment funds in which these funds invest. An investment in a hedge fund involves the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use of leverage, short sales, options, futures, derivative instruments, investments in non-U.S. securities, “junk” bonds and illiquid investments. There can be no assurances that a manager’s strategy (hedging or otherwise) will be successful or that a manager will use these strategies with respect to all or any portion of a portfolio.

Private capital funds are complex, speculative investment vehicles and are not suitable for all investors. They are generally open to qualified investors only and carry high costs, substantial risks, and may be highly volatile. There is often limited (or even non‐existent) liquidity and a lack of transparency regarding the underlying assets. They do not represent a complete investment program. The investment returns may fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Private capital funds are not required to provide investors with periodic pricing or valuation and are not subject to the same regulatory requirements as mutual funds. Investing in private capital funds may also involve tax consequences. Speak to your tax advisor before investing. An investment in a private capital fund involves the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use of leverage and illiquid investments. There can be no assurances that a manager's strategy will be successful or that a manager will use these strategies with respect to all or any portion of a portfolio.

Privately offered real estate funds are speculative and involve a high degree of risk. Investments in real estate and real estate investments trusts have special risks, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions. There can be no assurance a secondary market will exist and there may be restrictions on transferring interests.

Global Hedge Funds: The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 singlemanager funds that report to HFR Database. Constituent funds report monthly net-of-all-fees performance in U.S. dollars and have a minimum of $50 million under management or a 12- month track record of active performance. The HFRI Fund Weighted Composite Index does not include Funds of Hedge Funds.

Relative Value Arbitrage: The HFRI Relative Value Index. Maintains positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types. Fixed income strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. RV position may be involved in corporate transactions also, but as opposed to ED exposures, the investment thesis is predicated on realization of a pricing discrepancy between related securities, as opposed to the outcome of the corporate transaction.

Arbitrage: The HFRI RV: Fixed Income-Convertible Arbitrage Index. Includes strategies in which the investment thesis is predicated on realization of a spread between related instruments in which one or multiple components of the spread is a convertible fixed income instrument. Strategies employ an investment process designed to isolate attractive opportunities between the price of a convertible security and the price of a nonconvertible security, typically of the same issuer. Convertible arbitrage positions maintain characteristic sensitivities to credit quality the issuer, implied and realized volatility of the underlying instruments, levels of interest rates and the valuation of the issuer's equity, among other more general market and idiosyncratic sensitivities.

Long / Short Credit: The HFRI RV: Fixed Income—Corporate Index. Includes strategies predicated on realization of a spread between related instruments in which one or multiple components of the spread is a corporate fixed-income instrument. Strategies are designed to isolate attractive opportunities between a variety of fixed income instruments, typically realizing an attractive spread between multiple corporate bonds or between a corporate and risk free government bond. They typically involve arbitrage positions with little or no net credit market exposure, but are predicated on specific, anticipated idiosyncratic developments.

Structured Credit/Asset Backed: The HFRI RV: Fixed Income-Asset Backed Index. Includes strategies predicated on realization of a spread between related instruments in which one or multiple components of the spread is a fixed-income instrument backed by physical collateral or other financial obligations (loans, credit cards) other than those of a specific corporation. Strategies are designed to isolate attractive opportunities between a variety of fixed income instruments specifically securitized by collateral commitments, which frequently include loans, pools and portfolios of loans, receivables, real estate, machinery or other tangible financial commitments. Investment thesis may be predicated on an attractive spread given the nature and quality of the collateral, the liquidity characteristics of the underlying instruments and on issuance and trends in collateralized fixed-income instruments, broadly speaking. In many cases, investment managers hedge, limit, or offset interest-rate exposure in the interest of isolating the risk of the position to strictly the disparity between the yield of the instrument and that of the lower-risk instruments.

Macro: The HFRI Macro Index: Macro. Investment Managers which trade a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities. In a similar way, while both Macro and equity hedge managers may hold equity securities, the overriding investment thesis is predicated on the impact movements in underlying macroeconomic variables may have on security prices, as opposes to EH, in which the fundamental characteristics on the company are the most significant are integral to investment thesis.

Systematic Macro. HFRI Macro: Systematic Diversified Index. Diversified strategies employing mathematical, algorithmic and technical models, with little or no influence of individuals over the portfolio positioning. Strategies are designed to identify opportunities in markets exhibiting trending or momentum characteristics across individual instruments or asset classes. Strategies typically employ quantitative processes which focus on statistically robust or technical patterns in the return series of the asset, and they typically focus on highly liquid instruments and maintain shorter holding periods than either discretionary or mean-reverting strategies. Although some strategies seek to employ counter-trend models, strategies benefit most from an environment characterized by persistent, discernible trending behavior. Typically have no greater than 35 percent of portfolio in either dedicated currency or commodity exposures over a given market cycle.

Discretionary Macro. HFRI Macro: Discretionary Thematic Index. Strategies primarily rely on the evaluation of market data, relationships and influences, as interpreted by individuals who make decisions on portfolio positions; strategies employ an investment process most heavily influenced by top-down analysis of macroeconomic variables. Investment Managers may trade actively in developed and emerging markets, focusing on both absolute and relative levels on equity markets, interest rates/fixed income markets, currency and commodity markets; they frequently employ spread trades to isolate a differential between instrument identified by the Investment Manager as being inconsistent with expected value. Portfolio positions typically are predicated on the evolution of investment themes the Manager expects to develop over a relevant time frame, which in many cases contain contrarian or volatility-focused components.

Event Driven: The HFRI Event Driven Index: Event-Driven. Investment Managers who maintain positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.

Activist: HFRI ED: Activist Index. Strategies may obtain or attempt to obtain representation on the company’s board of directors in an effort to impact the firm’s policies or strategic direction and in some cases may advocate activities such as division or asset sales, partial or complete corporate divestiture, dividends or share buybacks, and changes in management. Strategies employ an investment process primarily focused on opportunities in equity and equity-related instruments of companies that are currently or prospectively engaged in a corporate transaction, security issuance/repurchase, asset sales, division spin-off or other catalystoriented situation. These involve both announced transactions and situations in which no formal announcement is expected to occur. Activist strategies would expect to have greater than 50 percent of the portfolio in activist positions, as described.

Distressed Securities: HFRI Distressed/Restructuring Index. Strategies focused on corporate fixed-income instruments, primarily corporate credit instruments of companies trading at significant discounts to their value at issuance or obliged (par value) at maturity as a result of either formal bankruptcy proceedings or financial-market perception of near-term proceedings. Managers are typically actively involved with the management of these companies; they are frequently involved on creditors’ committees in negotiating the exchange of securities for alternative obligations, either swaps of debt, equity or hybrid securities. Managers employ fundamental credit processes focused on valuation and asset coverage of securities of distressed firms; in most cases portfolio exposures are concentrated in instruments that are publicly traded, in some cases actively and in others under reduced liquidity but in general for which a reasonable public market exists. Strategies employ primarily debt (greater than 60 percent) but also may maintain related equity exposure.

Merger Arbitrage: HFRI ED: Merger Arbitrage Index. Strategies primarily focused on opportunities in equity and equity-related instruments of companies that are currently engaged in a corporate transaction. Merger Arbitrage involves primarily announced transactions, typically with limited or no exposure to situations in which no formal announcement is expected to occur. Opportunities are frequently presented in cross-border, collared, and international transactions that incorporate multiple geographic regulatory institutions, typically with minimal exposure to corporate credits. Strategies typically have over 75 percent of positions in announced transactions over a given market cycle.

Equity Hedge: HFRI Equity Hedge (Total) Index. Investment Managers who maintain positions both long and short in primarily equity and equity derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios. EH managers would typically maintain at least 50 percent exposure to, and may in some cases be entirely invested in, equities, both long and short.

Directional Equity: HFRX EH: Multi-Strategy Index. Managers maintain positions both long and short in primarily equity and equity-derivative securities. A wide variety of investment processes can be employed to arrive at an investment decision, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage, holding period, concentrations of market capitalizations, and valuation ranges of typical portfolios. Managers typically do not maintain more than 50 percent exposure to any one Equity Hedge sub-strategy.

Equity Market Neutral: HFRI EH: Equity Market Neutral Index. Strategies employ sophisticated quantitative techniques to analyze price data to ascertain information about future price movement and relationships between securities. These can include both Factor-based and Statistical Arbitrage/Trading strategies. Factor-based investment strategies include strategies predicated on the systematic analysis of common relationships between securities. In many cases, portfolios are constructed to be neutral to one or multiple variables, such as broader equity markets in dollar or beta terms, and leverage is frequently employed to enhance the return profile of the positions identified. Statistical Arbitrage/Trading strategies consist of strategies predicated on exploiting pricing anomalies which may occur as a function of expected mean reversion inherent in security prices; high-frequency techniques may be employed; trading strategies may also be based on technical analysis or designed opportunistically to exploit new information that the investment manager believes has not been fully, completely, or accurately discounted into current security prices. Strategies typically maintain characteristic net equity market exposure no greater than 10 percent long or short.

Global Equities: MSCI All Country World Index (ACWI). Captures large and mid-cap representation across 23 developed markets and 23 emerging markets countries. With over 2,000 constituents, the index covers approximately 85% of the global investable equity opportunity set.

Global Fixed Income: Barclays Global Aggregate Sovereign Total Return Index. A measure of global investment-grade debt from 24 different local currency markets. This multi-currency benchmark includes fixed-rate treasury, government-related, corporate and securitized bonds from both developed and emerging markets issuers.

Global Credit: Barclays Global Aggregate Credit Total Return Index. Represents the corporate and government-related sectors of Barclays Capital Global Aggregate Bond Index (which provides a broad-based measure of the global investment-grade, fixed-rate debt markets) and is considered representative of global investment-grade debt.

The information contained in this document has been prepared by Global Investment Strategy (GIS) and Global Alternative Investments (GAI) and the opinions are those of GIS and GAI. The views expressed are subject to change and are not intended as investment advice. GIS and GAI do not undertake to advise you of any change in its opinion or of the information contained herein. The information or analysis contained in this material has been compiled or arrived at from sources believed to be reliable but GIS and GAI do not make any representations as to their accuracy or completeness and does not accept liability for any loss arising from the use thereof.

Global Investment Strategy and Global Alternative Investments are divisions of Wells Fargo Investment Institute (WFII). WFII is a registered investment adviser and wholly‐owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. Global Alternative Investment Services, Inc. is a registered broker‐dealer that acts as placement agent for certain funds and provides wholesaling support services to GAI.

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