Global Alternative Investments

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

November 2016

Adam Taback, Head of Global Alternative Investments

James Sweetman, Sr. Global Alternative Investment Strategist

Justin Lenarcic, Global Alternative Investment Strategist

Managers Turn Defensive before Election

  • Hedge fund returns were negative in October, but outperformed global equities, credit and fixed income.
  • Systematic Macro strategies again 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 estimates from Hedge Fund Research (HFR) indicate modestly negative performance in October, stemming seven straight months of positive returns. Relative performance, however, was strong given that both global and domestic equities faced headwinds, especially U.S. small caps. Overall, Equity Hedge managers benefited from a fertile environment for security selection, driving short alpha that helped offset losses from long positions. Within Event-Driven, the Distressed/Restructuring sub-strategy was again a standout performer, as spreads tightened over the course of the month driving mark-to-market gains. Although it was a historic month in terms of deal activity/volume, Merger Arbitrage and Special Situation equity managers were negatively affected by increased deal scrutiny, which led to merger spreads widening across the deal universe. Credit-oriented Relative Value managers benefited from increased demand and inflows into structured credit products, specifically CLO’s. The Systematic Macro strategy had another difficult month, as losses continue to persist from long fixed income positions. Although not as severe, long gold positions also detracted from performance due to the trend reversal that began in late September continuing through October. Discretionary Macro managers navigated the market volatility more efficiently by avoiding the sporadic and severe spikes in yields, and benefiting from more niche investment themes and security selection in Emerging Markets.

Alternative Investment Strategy Indices—Performance Snapshot As of 10/31/16  Alternative Investment Strategy Indices—Performance Snapshot As of 10/31/16 Returns over one year are annualized. Index performance is as reported by HFR and as of the date above. 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.

Market Observations

Overall, hedge fund portfolios took on a decidedly defensive tone in October, as concerns around the election and the impact of the expected December rate hike led to an increase in volatility. Relative Value managers, especially those focused on Long/Short Credit, have monetized some of the positions bought earlier in the year and have used the proceeds to raise cash balances to position themselves more defensively heading into year-end. Additionally, Macro managers have also reduced risk with Systematic Macro strategies positioned significantly net short equities entering November. Discretionary Macro managers are taking note of the increase in inflation, both real and expected, and the impact on global financial assets. A flurry of deal activity took place in recent weeks, which should provide trading opportunities for Event Driven managers, especially given the antitrust scrutiny and increased risk resulting in a widening of merger spreads.

Global Alternative Investment Perspective

Overall, the Relative Value strategy remains supported by fundamentals including a strong U.S. consumer and a stable commercial real estate sector. We remain constructive on the outlook for structured credit, especially relative to high-yield corporate credit, which appears to be exhibiting late-cycle behavior. Therefore, we 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 is 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 Credit over the medium term. We believe there are potential catalysts outside of the energy sector that may lead to an attractive entry point for distressed credit investing. We believe weaker underwriting standards and regulatory changes sets the stage for a gradual increase in default rates, fallen angels and other credit events that can present attractive opportunities for Distressed Credit managers.

We continue to view Equity Hedge (specifically less directional strategies with low-net equity exposure, defined as 20 to 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 cautious-but-constructive outlook on the equity markets while mitigating risk.

We remain highly constructive on several prospective Private Capital opportunities and recommend that investors continue to diversify their private capital investments by vintage year. 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. Despite the recent reduction in core commercial property values, we still believe many core markets are fully priced or overpriced for new capital investment. However, we believe there are compelling opportunities, especially in more opportunistic global strategies.

Rationale for Recommended Tactical Tilts – As of 10/1/2016

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

Overweight

Structured Credit fundamentals remain supportive, although we are cognizant that trends in property prices and delinquencies have softened marginally. We view the risk-reward tradeoff within Structured Credit as more attractive than traditional fixed income, and believe investors can benefit from the high cash flow generated by the securities.

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

Even Weight

The strategy’s historically low correlation to risk assets has the potential to benefit investors in the event of a prolonged correction, when it may help provide downside protection and even positive performance. However, choppy trading conditions can 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

Underweight

Deal volume increased significantly in October, which should present trading opportunities for Merger Arbitrage managers. Distressed Credit managers have benefited from tightening credit spreads, with many realizing gains and raising cash in anticipation of better opportunities over the coming months.

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

Overweight

We believe this is a stock picker’s environment; however, low-net global equity exposure is preferred over more directional exposure. Sector dispersion has increased as third quarter earnings season has progressed, which is resulting in an improved environment for both long and short alpha generation.

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 with an increased focus on Asia. Going forward, we expect that income will comprise a larger portion of total return for core real estate than it has for the past five years.

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. Other risks may apply as well, depending on the specific investment product. Alternative Investments are speculative investments and are not suitable for all investors, nor do they represent a complete investment program. Such funds are not subject to the same regulatory requirements as mutual funds. The Feeder Fund is only open to qualified investors who are comfortable with the substantial risks associated with investing in such funds. The Master Fund(s) investment program (and thus an investment in the Feeder Fund) is speculative and entails substantial risks. An investment in the Master Fund(s) (and thus an investment in the Feeder Fund) may include the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use of leverage, arbitrage, short sales, options, futures, derivative instruments and investment in non-US securities, "junk" bonds and illiquid investments. In particular, the Master Fund(s) may use leverage in making investments, including investments in underlying funds, and underlying fund managers also may employ leverage through a number of measures, either of which could increase any loss incurred. The more leverage employed, the more likely a substantial change will occur, either up or down, in the value of the investment. There can be no assurances that the strategy pursued by the Master Fund(s) manager will be successful or that the Master Fund(s) manager will employ such strategies with respect to all or any portion of a portfolio. Past performance is not indicative of future results. Investments in the Feeder Fund are suitable only for an investor who can bear the risks associated with the limited liquidity of this investment and who can bear the possibility of the complete loss of this investment.

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.

An index is unmanaged and not available for direct investment.

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 Alternative Investments (GAI) and Global Manager Research are divisions of Wells Fargo Investment Institute, Inc. (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.

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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