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Outlook 2017

Hedge fund managers see smooth sailing

Luke Ellis
Luke Ellis called the market reaction that followed Donald Trump's election a pleasant surprise.

Hedge fund managers are singing much the same optimistic refrain for 2017 as they did for 2016, but with much more conviction and a nod to President-elect Donald Trump for setting the stage for the kind of rough markets in which their strategies will thrive.

At the top of managers' new year's expectations is much higher volatility coupled with lower cross-market correlations and higher stock dispersion in global markets, which is almost exactly what they predicted for 2016.

Hedge fund manager wishes stand a good chance of being granted next year through the potent combination of European political uncertainty, mismatched global economies, less quantitative easing, higher interest rates and increased market risk that will characterize the coming year, according to the prognostications of most of the executives interviewed by Pensions & Investments about their expectations for 2017.

Despite widespread anticipation of large-scale change, there's an element of back-to-the future for hedge fund managers, observers said.

“At a high level, the 2017 themes are the same as last year, but their likelihood of success is stronger and manager conviction much firmer,” said Jon Hansen, managing director and hedge fund specialist based in the Boston headquarters of consultant Cambridge Associates LLC.

The beginning of 2016, especially the first quarter, was very tough on the hedge fund industry, resulting in disappointing performance and very low morale, Mr. Hansen said. But by midyear, performance had started to rise along with morale and investment opportunities.

The same broad elements of 2016 hedge fund success likely will be enhanced and strengthened in 2017 given “the much more favorable environment” under a Trump presidency, Mr. Hansen said.

Those key pieces include high equity dispersion; normalization of interest rates that is a return to “the true cost of capital ... monetary (easing) policy is a challenge to hedge fund managers;” and pockets of elevated volatility generated by fiscal or trade policy reform or market movements that “generate a return for your research and security selection,” Mr. Hansen stressed.

“More deregulation than at any other time since (Ronald) Reagan's presidency is certainly on the agenda,” predicted Michael Hintze, CEO and senior investment officer of credit specialist CQS (UK) LLP, London, in his annual outlook report to investors.

The degree to which quantitative easing will continue — a top-of-mind macro trend for many hedge fund managers, sources said — is a matter of where in the world you look, said CQS' Mr. Hintze in his report.

“In the U.S., further QE is over for now and it seems to me that the appetite for QE is waning in the U.K., although the eurozone, China and Japan continue to run accommodative monetary policies,” Mr. Hintze said.

CQS manages $12 billion in a variety of hedge fund and long-only credit strategies.

Surprised and delighted

Hedge fund managers were surprised — and delighted to some extent — by global market reaction to Mr. Trump's successful candidacy.

“Three months ago, I would have said the hedge fund industry was headed into a tough year in 2017,” said Luke Ellis, CEO of Man Group PLC, London, pointing to depressed returns for most hedge fund strategies year-to-date through Sept. 30. “There's been a radical change in the six weeks since the election. Performance has been pretty good and you could almost see what (Mr.) Trump will do, which is not what the other guys did,” Mr. Ellis stressed.

Mr. Ellis' prediction is for lower cross-market correlations and higher stock dispersion, adding that for hedge fund managers, “we struggle when correlations are high and dispersion is low, but do well when they are reversed.”

Man Group manages $81 billion in hedge fund and hedge fund-of-funds assets.

“There's a reading of the tea leaves going on now about how U.S. tax, trade, immigration and other regulatory reforms will impact the world. There's a tremendous amount of uncertainty,” said Gideon Berger, senior managing director and head of risk management at Blackstone Alternative Asset Management, New York.

High levels of uncertainty likely will result in more and larger global market movements spanning higher volatility, “an environment in which hedge funds, particularly global macro strategies, tend to do well vs. benign conditions when there isn't enough movement to exploit,” Mr. Berger stressed.

BAAM manages $70 billion in hedge funds of funds and customized hedge fund portfolios.

Among the specific levers expected to help hedge fund performance is the strengthened case for “for an inflection in yields and inflation. Heading into 2017, we expect less monetary support and more fiscal push to make active managers' lives easier,” wrote Jean-Baptiste Berthon, senior cross-asset strategist, Lyxor Asset Management, Paris, in the firm's December edition of Alternative Investment Industry Barometer report.

“On the one hand, higher rates and inflation could result in more fundamental pricing, supporting more typical asset relationships,” Mr. Berthon said. “On the other hand, Trump's key proposals open various sector themes likely to foster asset dispersion. This environment should put an end to a year and a half of anemic alpha generation,” for hedge fund managers, he added.

Hedge fund practitioners are rubbing their hands together in anticipation of a strong 2017. “I am very excited about prospects next year. We're already seeing some positive changes since the presidential election, such as the change in the interest rate and a general shift in the economic outlook,” said Clint D. Carlson, president and CEO, Carlson Capital LP, Dallas.

The 2017 investment environment is likely to be a good for Carlson Capital's hedge fund strategies, particularly with regard to the expected continued rise of interest rates because “higher rates will reduce competition” for bonds, which will give the remaining managers more ways to protect themselves from market risk and increase return dispersion.

Mr. Carlson said his team has been bullish on its risk arbitrage strategy for about a year and still sees “a tremendous number of opportunities,” which can be riskier but presents great value without much downside because spreads are so wide.

Carlson Capital manages $8.5 billion in credit and equity hedge funds.

The investment team at structured credit specialist Ellington Management Group LLC, Old Greenwich, Conn., sees big opportunity in plumbing the depths of the global semi-liquid credit market from which big banks have pulled back and “no one else has stepped in to fill the void,” said Robert Kinderman, managing director and portfolio manager.

“There is very high alpha compared to the credit and liquidity risk in these investments,” he said, which include legacy collateralized-loan obligations and non-performing middle-market loans in the U.K., the U.S. and Europe.

“These are highly tradable assets that can be sold in days, not weeks or years, for which there isn't a lot of competition, because they're complicated and really do require an experienced buyer,” he added.

Ellington manages $6 billion in structured credit hedge funds.

One voice among the sources P&I interviewed was not wildly optimistic about hedge fund managers' fortunes in the coming year. “I expect more of the same,” said James C. McKee, senior vice president and director of hedge fund research for investment consultant Callan Associates Inc., San Francisco.

“Forecasting uncertainty is just as tough as forecasting returns. You can't do it,” Mr. McKee said, adding the downside risk hedge fund managers need to generate returns is “not palpable. It's surreal. As long as central banks continue to interfere with fiscal policy, the environment won't be good for hedge funds.”

This article originally appeared in the December 26, 2016 print issue as, "Managers seeing volatility ahead and expect to thrive".