Alternatives Strategy

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

June 2017

Adam Taback, Head of Global Alternative Investments
James Sweetman, Sr. Global Alternative Investment Strategist
Justin Lenarcic, Global Alternative Investment Strategist

Positive Returns Across the Board in May

  • Hedge fund returns were positive in May, but underperformed global equities, credit and fixed income.
  • Event Driven, Equity Hedge and Macro were the strongest performing strategies, followed by Relative Value.
  • We maintain a tactical Overweight recommendation for Relative Value and Equity Hedge, and an Even Weight for Macro and Event Driven.

Early estimates for May from HFR (Hedge Fund Research, Inc.) indicate a 7th consecutive month of positive returns for the industry and the fourteenth out of the last fifteen. The Structured Credit market continues to receive fundamental support, as US consumers benefit from historically low unemployment and still very affordable lending rates. Systematic Macro managers faced strong declines mid-month with a sharp decline in the USD and rise in oil prices, but fortunately their long equity positioning helped offset these steep losses by month-end. Discretionary Macro strategies encountered volatility in emerging markets, as allegations of fraud roiled the Brazilian equity and fixed income markets. Event-Driven managers had another month of quality deal activity domestically and abroad, with additional rumored activity for the coming months. Long-Short Equity managers continued generating long and short alpha, even as stock correlations spiked mid-month with the rise in volatility.

Alternative Investment Strategy Indices—Performance Snapshot As of 5/31/2017 Alternative Investment Strategy Indices—Performance Snapshot As of 5/31/2017Returns over one year are annualized. Index performance is as reported by Hedge Fund Research, Inc. (HFR) on the date shown. HFR may adjust performance due to late reporting by index components. Past performance is no guarantee of future results. Please see below for index definitions. An index is unmanaged and not available for direct investment.

Relative Value: Structured Credit spreads continued tightening in May, with both mezzanine mortgage-backed securities and legacy residential mortgage-backed securities seeing modest price appreciation. Weakness in the retail sector continues to persist, with some managers shorting CMBX indices that have heavy retail exposure.

Macro Strategies: It was a very volatile month for Systematic Macro strategies. They experienced sharp mid-month declines from long USD and short energy positioning, as the USD weakened from US political tensions, and oil surged with OPEC extending production cuts through March of 2018. Managers recovered from these declines from long equity positioning, as equities rallied toward month-end.

Event Driven: Corporate deal activity continued at a very healthy pace, with notable domestic deals announced including the bio-technology and telecommunications sectors, along with rumored deals with larger consumer goods and internet radio companies. Encouragingly, cross border announced deals that included the largest foreign acquisition for an Italian company since 2007, with the announced merger of an Italian and Spanish infrastructure company.

Equity Hedge: With the mid-month surge in volatility, a prime brokerage report noted the third largest drop in net leverage in 8 years among Equity Hedge managers. However, substantial buying ensued as managers bought into the market’s weakness that was created from uncertainty surrounding the US administration, as net exposure remains near multi-year highs backed by stronger earnings and improving economies in the US and Europe.

Market Observations

Hedge Fund managers continue reallocating capital to European markets, as the region experienced a very strong corporate earnings season, which is on track for the strongest quarter in a decade. Equity managers have noted defensive positioning in US technology and energy sectors. Concerns stem from the tech IPO pipeline including slower growth companies avoiding private capital raises at lower valuations, and energy companies pushing back 2017 guidance as they build production pipelines, but are struggling to generate returns from such investments.

Wells Fargo Investment Institute Perspective

Relative Value: Fundamentals remain supportive, although we recognize that trends in property prices and delinquencies have softened marginally, especially in the retail sector. We view the risk-reward tradeoff within Structured Credit as more attractive than traditional fixed income, and believe that investors can benefit from the high cash-flow potential of this strategy.

Macro: This strategy’s historically low correlation to risk assets should benefit investors in the event of a prolonged correction, when it can help provide downside protection and potentially positive performance. However, we prefer the Macro Discretionary strategy over the Systematic Macro strategy, as choppy trading conditions might limit the effectiveness of the Systematic Macro strategy when established trends abruptly reverse.

Event Driven: We see an improvement in the opportunity set for Event Driven strategies, in particular within Distressed Credit. Though spreads are tight and defaults are currently low, rising interest rates and a fundamentally-challenged Retail sector may provide opportunities as the credit cycle matures.

Equity Hedge: We believe that this is a stock picker’s environment; however, low-net global equity exposure is preferred over more directional exposure. Sector dispersion remains elevated, resulting in an improved environment for gains on both the long and short sides.

Private Capital: We remain highly constructive on several prospective Private Capital opportunities and recommend that qualified, financially sophisticated investors continue to diversify their Private Capital investments by vintage year. Our even weight position is more representative of our tepid outlook on the Large Buyout strategy, rather than a lack of opportunities in Private Capital, particularly opportunities within Private Debt as well as niche and specialty private capital strategies.

Private Real Estate: We prefer opportunistic real-estate strategies, particularly in Europe, but also strategies with an increased focus on Asia. Going forward, we expect that income will represent a larger portion of total return for core real estate than it has for the past five years.

Rationale for Recommended Tactical Tilts – As of 6/1/2017

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

Overweight

Fundamentals remain supportive, although we recognize that trends in property prices and delinquencies have softened marginally, especially in the retail sector. We view the risk-reward tradeoff within Structured Credit as more attractive than traditional fixed income and believe that investors can benefit from the high cash-flow potential of this strategy.

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

Even Weight

This strategy’s historically low correlation to risk assets should benefit investors in the event of a prolonged correction, when it can help provide downside protection and potentially positive performance. However, choppy trading conditions might limit the effectiveness of the Systematic Macro strategy when established trends abruptly reverse.

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

Even Weight

Deal volume has slowed in recent weeks, but remains supportive. This should present trading opportunities for Merger Arbitrage managers. Distressed Credit managers have benefited from a stable environment, with many realizing gains and raising cash in anticipation of better opportunities in coming months.

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

Overweight

We believe that this is a stock picker’s environment; however, low-net global equity exposure is preferred over more directional exposure. Sector dispersion remains elevated, resulting in an improved environment for gains on both the long and short sides.

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

Even Weight

We are most constructive on international Distressed/Special Situation strategies, particularly in Europe, where opportunities should continue to unfold. We believe that large-cap buyouts will be challenged due to high valuations, but remain constructive on small- and mid-cap buyouts.

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

Even Weight

We prefer opportunistic real-estate strategies, particularly in Europe, but also for those strategies with an increased focus on Asia. Going forward, we expect that income will represent a larger portion of total return for core real estate than it has for the past five years.

Risk Factors

Alternative investments, such as hedge funds, funds of hedge funds, managed futures, private capital, real assets and real estate funds, are not suitable for all investors. They are speculative, highly illiquid, and are designed for long-term investment, and not as trading vehicles. There is no assurance that any investment strategy pursued by the Master Fund (and thus the Feeder Fund) will be successful or that a fund will achieve its intended objective. Investments in these funds entail significant risks, volatility and capital loss including the loss of the entire amount invested. The increased risk of investment lost is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund for which the fund does not represent a complete investment program. These funds carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. The high expenses associated with alternative investments must be offset by trading profits and other income which may not be realized. Unlike mutual funds, alternative investments are not subject to some of the regulations designed to protect investors and are not required to provide the same level of disclosure as would be received from a mutual fund. They trade in diverse complex strategies that are affected in different ways and at different times by changing market conditions. Strategies may, at times, be out of market favor for considerable periods with adverse consequences for the fund and the investor. An investment in these funds involve the risks inherent in an investment in securities and can include losses associated with speculative investment practices, including hedging and leveraging through derivatives, such as futures, options, swaps, short selling, investments in non-U.S. securities, “junk” bonds and illiquid investments. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. At times, a fund may be unable to sell certain of its illiquid investments without a substantial drop in price, if at all. Other risks can include those associated with potential lack of diversification, restrictions on transferring interests, no available secondary market, complex tax structures, delays in tax reporting, valuation of securities and pricing. An investment in a fund of funds carries additional risks including 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 investor should review the private placement memorandum, subscription agreement and other related offering materials for complete information regarding terms, including all applicable fees, as well as the specific risks associated with a fund before investing.

Global Hedge Funds: The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager 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 catalyst-oriented 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 Bloomberg Barclays 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 Wells Fargo Investment Institute (WFII) and the opinions are those of WFII. The views expressed are subject to change and are not intended as investment advice. WFII does 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 WFII does not make any representations as to their accuracy or completeness and does not accept liability for any loss arising from the use thereof.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

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. 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.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.

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