Alpha opportunities seen from continuing volatility

Hedge fund managers are confident that 2015 will — at last — bring the levels of volatility and dispersion they need to outperform equity markets and re-establish their reputation as alpha generators.

It took nine long months for the volatility to appear for which hedge fund managers interviewed for Pensions & Investments' 2014 outlook story said they had been crossing their fingers. Managers interviewed about their outlook for 2015 are sure that volatility will continue with a vengeance.

“You have to understand where we are coming from. Part of the end game of global regulators was to depress volatility to bring the markets back after the financial crisis,” said Patrick McMahon, founder, CEO and chief investment officer of credit hedge fund shop MKP Capital Management LLC, New York.

“Volatility was really low for the first nine months of this year, and most securities were trading risk on/risk off in sync. As an alpha producer, you were sitting there watching beta going up and down, but over the last three months, volatility has made things a lot more interesting,” Mr. McMahon added.

MKP managed $8.7 billion as of Dec. 1.

Volatility spiked sharply during the week of Oct. 13 in what sources referred to as a unique confluence of events, including a sharp drop in oil prices and concern over economic strength in the eurozone.

Hedge fund executives said 2015's volatility scenario likely will provide the sort of disruptions in which their portfolio managers can find plenty of investment opportunities. They broadly agreed that strategies most likely to perform well next year include global macro, managed futures, event-driven, long/short equity and fixed income.

“Asset values ... were intentionally propped up around the globe for the last six years to prevent the banking system from having to drain their balance sheets,” said Frank Brosens, co-founder and risk manager at Taconic Capital Advisors LP, New York, which managed $8.7 billion in event-driven multistrategy hedge funds as of Dec. 1.

Increased volatility creates “more disruption and much better investment opportunities,” a trend Mr. Brosens said is likely to continue for some years to come.

One thing is clear to observers and hedge fund managers: As valuations normalize and market volatility continues, hedge fund managers stand a much better chance at making money on the short side of equity and fixed-income trades than they have for some years.

“The long side will be better than last year, but the past won't be prologue. The best returns likely will be on the short side in 2015,” stressed Joel M. Greenblatt, managing principal and co-chief investment officer, Gotham Asset Management LLC, New York.

“There could be some really great opportunities on the short side with currently very expensive stock prices if the market drops,” Mr. Greenblatt said.

Gotham managed $9.5 billion in long/short equity strategies as of Dec. 1.

Among the areas that could be ripe for short-side profits are what Michael Hintze termed “potholes” scattered across global econ-omies, including geopolitical problems, oil price declines and terrorist activities.

In particular, if the tension between Russia and Ukraine exacerbates, the Russian government and Russian corporations might find it hard to meet debt obligations they have with European central banks, which might make shorting those banks an interesting bet, said Mr. Hintze, CEO and senior investment officer of multistrategy manager CQS (U.K.) LLP, London.

CQS managed $14.4 billion as of Dec. 1.

Worldwide “persistent and powerful” trends in commodity, currency, fixed income and equity markets will leave global macro and managed futures managers particularly poised to do well in 2015, said Kenneth J. Heinz, president of industry tracker Hedge Fund Research Inc., Chicago.

Global macro manager Kenneth G. Tropin, chairman of Graham Capital Management LP, Rowayton, Conn., said trends he'll be watching next year include Japan's weak yen and continued monetary policy, quantitative easing by the European Central Bank in the first quarter, strong U.S. employment data, and the likelihood that the U.S. and the U.K. will raise interest rates.

“Then add the political situation in Eastern Europe, unrest in the Middle East and a price war over oil and you see the end of the six years golden years of beta. I am very excited about the macro environment in 2015,” Mr. Tropin said.

However he warned: “Once the volatility genie is let out of the bottle, it sometimes takes a long time to put it back in.”

Graham Capital managed $7.9 billion as of Dec. 1.

Credit hedge fund managers also see strong investment possibilities emerging in 2015, although their geographic and debt structure focus varies widely.

Whitebox Advisors LLC's Paul Twitchell, partner and global head of event strategies, is bullish on U.S. fixed income relative to the rest of the world. The Minneapolis-based firm has investments in both U.S. structured products and “some really hairy credit, much further down into the credit structure,” Mr. Twitchell said.

“We like volatility and we like distressed debt. We see a lot of opportunity in energy-related distressed debt,” Mr. Twitchell said, adding that energy companies could find it hard to find financing from traditional channels.

“But although it's not an easy trade — you have to have the stomach for it — supplying secured debt to energy companies at a certain price could help us generate good returns,” Mr. Twitchell said.

Whitebox managed $4.3 billion in multistrategy and credit hedge funds as of Oct. 31.

Los Angeles-based Canyon Partners LLC is judiciously “laying our bets” on European real estate-backed loans, adding to the $4 billion it already has invested in the U.K., Ireland and Germany, said Joshua S. Friedman, founding partner, co-chairman and co-CEO.

Because of very tight liquidity across global markets, but especially among European central banks, Mr. Friedman said “this is a competitive market among just a few private equity and hedge fund managers.”

Canyon Partners managed $24 billion as of Dec. 1 in hedge funds and other alternative investment strategies.

SEER Capital Management LP, New York, is focused on “the re-emergence of the subprime mortgage market,” said Philip N. Weingord, managing partner and CEO.

SEER portfolio managers are slowly building a portfolio of newly originated, non-agency, non-qualified mortgages that U.S. banks are allowed to provide to low-income or credit-impaired buyers but are loath to do so after the problems they experienced after the financial crisis.

Less than $1 billion of non-QM loans were originated in 2014, but Mr. Weingord estimated that the market could grow, albeit slowly, to as much as $150 billion over the next several years. Eventually, SEER will securitize the portfolio and sell the bonds to institutional investors, he said.

SEER managed $2.1 billion in credit strategies as of Dec. 1.

Like SEER Capital, long/short equity manager Highline Capital Management LLC, New York, also is focused on the U.S. market, with a view that the “biggest opportunities lie in companies or sectors that are evolving because they are complicated,” said Jacob W. Doft, CEO and portfolio manager.

“The end of QE in the U.S. will bring fixed-income volatility back to normal and equities also will resume the old normal. U.S. equities are more likely to outperform those of other countries because investor focus will be on fundamentals,” Mr. Doft said.

Highline is looking to very low-end consumer retail companies for “the greatest area of growth,” as the “shocking decline in oil prices and job growth” will help even out growth of the U.S. economy and put more money in the hands of low-income shoppers.

Highline managed $2.5 billion as of Dec. 1.

Eric M. Mindich, CEO of New York-based multistrategy hedge fund manager Eton Park Capital Management LP, is focused on international markets, especially Asian markets and particularly Japan. Mr. Mindich said he thinks there is so much opportunity in Japan's huge stock market now that the firm is more likely to be investing on the long side rather than the short.

“We're more optimistic about China, more contrarian, than many other investors. Valuations are very low there, and it's a good place for long/short equity investments. The big downward movement in oil prices is very significant for Chinese and Japanese companies,” Mr. Mindich said.

Eton Park managed $9 billion as of Dec. 1.