Alternatives Strategy

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

December 2017

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

Hedge Funds End Year on Positive Note

  • Hedge fund returns were positive December, and outperformed global fixed income and credit.
  • Event Driven was the strongest performing strategy, followed by Equity Hedge, Relative Value and Macro.
  • We maintain a tactical Overweight recommendation for Relative Value and Equity Hedge, and an Even Weight for Macro and Event Driven.

Early estimates from Hedge Fund Research, Inc. (HFR) indicate positive returns in December, aided by a supportive environment for both equities and credit, encouraging economic data, and passage of the tax-reform bill (now law). Capping off one of the best years for alpha in recent memory, Equity Hedge managers, especially those focused on growth and momentum, finished the year with positive returns. Event-Driven managers bounced back from a challenging November as larger merger deals in the media/telecommunication and semiconductor sectors stabilized, with the targets trading higher. Relative Value managers benefited from strength in the new issue commercial mortgage-backed security sector, which helped offset a flat return from non-agency residential mortgage-backed securities. Macro managers had a strong month overall, especially Systematic managers, as trend following strategies benefited from sustained price action in equity, currency and commodity markets.

Performance Snapshot As of 12/31/2017Performance Snapshot As of 12/31/2017For illustrative purposes only. Returns over one year are annualized. Index performance is as reported by HFR on the date shown. Because the HFR Indices are calculated based on information that is voluntarily provided, actual returns may be higher or lower than those reported. Past performance is no guarantee of future results. Please see below for index and strategy definitions. An index is unmanaged and not available for direct investment. Broad based index returns assume the reinvestment of dividends and other distributions, reflect general market results and do not reflect actual portfolio returns, the experience of any investor, or the impact of any fees, expenses or taxes applicable to an actual investment. Unlike most asset class indices, HFR Index returns reflect deduction for fees and expenses.

Relative Value: Tightening of corporate credit spreads in December continued to provide a supportive backdrop for Relative Value managers. Furthermore, spreads within certain sectors of Structured Credit tightened on strong economic data and tight supply.

Macro: The Macro strategy’s strongest contributions came from long energy, equity and base metals positioning as the sustained, upward trends in these markets continue to benefit trend following strategies. Notable detractors included long fixed-income positioning as yields rose in the U.S. and Europe during the risk-on environment.

Event Driven: Managers’ focus on deal diversity (from both a sector and geographic perspective) helped to drive monthly returns as cross-border deals involving European targets traded higher, and as deal-specific volatility declined in the U.S.

Equity Hedge: Equity Hedge managers finished a strong 2017 with December contributions stemming from the U.S. Telecom Services sector as net-neutrality was repealed, and from the financial sector, which is expected to be a major beneficiary of U.S. tax reform.

Market Observations

2017 proved to be a strong year for hedge funds, with all four strategies posting positive returns as equity and credit security selection improved amid a largely supportive market backdrop. However, historically low volatility reduced the number of attractive entry points, leading many strategies to capture growth and momentum, rather than exploit opportunities in value. Many strategies finished the year with higher levels of gross exposure, as sentiment improved with the passage of corporate tax reform.

Wells Fargo Investment Institute Perspective

Relative Value: While modest economic growth, home price appreciation, and low unemployment provide fundamental support to Structured Credit, we remain tactically overweight Relative Value largely because of the increase in corporate credit dispersion and the maturation of the credit cycle.

Macro: Macro strategies largely have adopted a risk-on tone in recent months, leading to levered equity and energy exposure. This could pose a risk in the event of a short-term correction. Regardless of current positioning, Macro strategies historically have provided useful diversification, and we maintain an even weight recommendation.

Event Driven: Corporate deal activity is robust, and it may accelerate in the wake of tax reform. We anticipate a near-term opportunity within Merger Arbitrage, followed by a better environment for Stressed and Distressed Debt investing as the cycle matures and overleveraged borrowers face challenges.

Equity Hedge: Correlations continue to trend lower, while geographic, industry, and sector dispersion increases. This is conducive to security selection and could provide compelling opportunities for alpha on the long and short side. We remain overweight Equity Hedge.

Private Capital: We remain highly constructive on 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 than it is reflective of limited opportunities in Private Capital—particularly opportunities within Private Debt as well as niche and specialty private-capital strategies.

Private Real Estate: We remain even weight Private Real Estate. Despite the recent reduction in core commercial property values, we believe that many core markets are fully priced or overpriced for new capital investment. We see potential opportunities in certain global strategies.

Rationale for Recommended Tactical Tilts – As of 1/1/2018

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

Overweight

Credit dispersion increased in December, which may be a precursor to wider spreads. We continue to see an improving environment for Long/Short Credit.

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

Even Weight

Long Energy and Equity exposure was a key factor for strong December performance. We continue to be concerned with high levels of leverage utilized within “risk on” trends.

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

Even Weight

While M&A was not as eventful in December as it was earlier in the quarter, we find the opportunity set is increasingly attractive, especially with the potential impact of tax reform on corporate balance sheets.

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

Overweight

We continue to see a decline in equity correlations, which is a tailwind for the strategy. Gross exposure declined modestly into year-end, but still remained above historical averages.

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

Even Weight

We believe that large-cap buyouts will be challenged due to high valuations, but we 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

Opportunistic real-estate strategies focused on Europe and Asia remain attractive relative to domestic core real estate, for which total return is more dependent on income than on potential price appreciation today.

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.

Strategy and Index Definitions

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: Bloomberg 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: Bloomberg 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 presentation is being furnished on a confidential basis to a qualified purchaser and sophisticated investor for informational and discussion purposes only and does not constitute an offer to sell or a solicitation of an offer to purchaser, or a recommendation regarding, any security. 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 Alternative Investments are divisions of Wells Fargo Investment Institute (WFII). WFII is a registered investment adviser and wholly‐owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

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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