Global Alternative Investments
Discussion of global alternative investments market action and what it may mean for investors.
Adam Taback, Head of Global Alternative Investments
James Sweetman, Sr. Global Alternative Investment Strategist
Justin Lenarcic, Global Alternative Investment Strategist
Long and Short Alpha Generation Improves
- Hedge fund returns were positive in September, and outperformed global equities, credit and 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.
Early performance estimates from Hedge Fund Research (HFR) indicate a seventh-consecutive month of positive performance for the industry with strong outperformance from the Equity Hedge strategy. Equity Hedge managers outperformed with technology, commodity sensitive and small cap equities gaining, as stock pickers provided alpha on the long and short side of their portfolios. Event Driven managers provided mixed results with the Merger Arbitrage sub-strategy benefiting from exposure to financial, software and technology services related deals. More directional sub-strategies such as Distressed were positive despite higher volatility returning to capital markets. Within Relative Value, Structured Credit performed well overall. Agency and Non-Agency MBS outpaced comparable corporate credit markets (investment and non-investment grade) while the Commercial Mortgage Backed Securities (CMBS) market underperformed because of broader macro concerns and higher issuance volumes. The Systematic Macro strategy had contributions from long equity and Japanese Yen positions, but these were offset by losses from long fixed income and short energy positions. Discretionary Macro managers tended to navigate the fixed income market volatility better by avoiding the abrupt rise in yields, and finished the month ahead of Systematic Macro managers.
As volatility returned in September managers have become more defensive, rotating out of cyclical stocks into more defensive stocks. Equity Hedge managers outperformed broader global equity markets in consecutive months, providing downside protection earlier in the month after a sharp rise in equity market volatility. As economic data was digested by the market in early September, bond yields rose as the market priced in a possible rate hike from the Federal Reserve by year-end. This resulted in losses for the Systematic Macro strategy, which were only partially recovered as yields finished lower toward month-end.
Global Alternative Investment Perspective
Overall, the credit markets remain supported by fundamentals including a strong U.S. consumer and a stable commercial real-estate sector. We continue to see an opportunity for structured credit, especially relative to high-yield corporate credit, which appears to be exhibiting late-cycle behavior. We therefore maintain our tactical overweight outlook for Relative Value.
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 trend reversals that could whipsaw the Systematic Macro strategy. However, we continue to favor the Discretionary Macro strategy as we believe it to be both more nimble and tactical in navigating shorter term volatility and trend reversals.
We maintain our underweight recommendation for Event Driven strategies, but see an improving opportunity set for Distressed Debt over the medium term. We believe there are potential catalysts on the horizon that may lead to an attractive entry point for distressed credit investing. Weaker underwriting standards and regulatory changes have raised questions regarding liquidity, and we believe this bodes well for the distressed credit strategy. Expectations are for a gradual increase in default rates, fallen angels and other credit events that can present attractive opportunities for Distressed Debt managers.
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 the likelihood of significant outperformance. Rather, it accentuates our outlook on being cautious but constructive on the equity markets while mitigating risk.
Overall, we are highly constructive on several Private Capital opportunities and believe the current environment provides opportunities for vintage year acceleration. Our even weight recommendation for the strategy is more a representation of our outlook on the Large Buyout strategy rather than a lack of strong opportunities in the Private Capital space, particularly with Private Debt.
We maintain an even weight recommendation for Private Real Estate. With a rate increase on the horizon in the US and the ongoing global economic slowdown, the rising tide that had previously lifted real estate investments over the last several years seems likely to recede. The cycle is clearly turning and the successful investment strategies of yesterday may not suit the conditions emerging today, but we believe there are compelling opportunities, especially in more opportunistic global strategies.
Rationale for Recommended Tactical Tilts – As of 10/1/2016
|Weight||Rationale and Further Detail|
|Asset Class - Hedge: Relative Value||
Structured Credit fundamentals remain supportive, although we are cognizant that trends in property prices and delinquencies have softened marginally. We view the risk-reward within structured credit as being more attractive than traditional fixed income, and believe investors can benefit from the high cash flow generated by the securities.
|Weight||Rationale and Further Detail|
|Asset Class - Hedge: Macro||
The strategy has historically exhibited low correlation to risk assets, and we believe this should benefit investors in the event of a prolonged correction by providing downside protection and even positive performance. However, choppy trading conditions can limit the effectiveness of the Systematic Macro strategy when established trends abruptly reverse.
|Weight||Rationale and Further Detail|
|Asset Class - Hedge: Event Driven||
M&A volume is down year-over-year and we still believe the strategy may be susceptible to bouts of episodic volatility as a result of macro-economic events, central bank policies and uncertain elections. As such, higher beta, equity-oriented sub-strategies like Activist could face headwinds. We believe there are potential catalysts on the horizon that may lead to an attractive entry point for Distressed credit investing.
|Weight||Rationale and Further Detail|
|Asset Class - Hedge: Equity Hedge||
We still believe this is a stock picker’s environment. However, low-net equity exposure is preferred over more directional exposure. The Equity Hedge strategy offers investors a strategy that will both participate and protect, while being focused on unlocking value and complementing traditional equity allocations.
|Weight||Rationale and Further Detail|
|Asset Class - Private Capital||
We are most constructive on international Distressed/Special Situation strategies, particularly in Europe, where opportunities should continue to unfold. We continue to believe large cap buyouts will be challenged due to high valuations, but remain constructive on small and mid-cap buyouts.
|Weight||Rationale and Further Detail|
|Asset Class - Private Real Estate||
We prefer Opportunistic real estate strategies, particularly in Europe, but also with increased focus on Asia. Despite the recent reduction in core commercial property values, we still believe that many core markets are fully priced or overpriced for new capital investment. Going forward, we believe that income will comprise a larger portion of the total return than it has over the last five years for core real estate.
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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