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Special report: Outlook 2018

Hedge fund managers eager to see return of disruption, volatility

Firms ready to deploy capital when time is right; some hint that could be soon

Mark E. Kingdon is predicting a favorable environment for hedge fund managers that go short in 2018, even if it’s more expensive to do.

Hedge fund managers are approaching 2018 with a high degree of enthusiasm and a craving for more volatility.

Industry executives broadly agreed that changing global economic and fiscal conditions will bring asset prices down, creating a better environment for active money management strategies generally and hedge funds in particular.

Hedge fund portfolio managers are waiting with bated breath for the volatile consequences of market disruptions, sharp shocks and abrupt revaluations likely as equity markets begin what sources said is an inevitable fall from their nearly decadelong, record-breaking streak.

Hedge fund managers are ready to deploy capital when the late-cycle U.S. equity and global credit markets reach the inflection point and begin to fall, said Jon Hansen, managing director and hedge fund specialist based in the Boston headquarters of consultant Cambridge Associates LLC.

Exactly when, where and how that inflection point and accompanying volatility will manifest themselves is impossible to predict, Mr. Hansen said, but he suggested they might not be long in coming. "We're just one event away from the (Cboe Volatility index) hitting the high teens and giving hedge fund managers what they need," he said.

Hedge fund managers said they already are taking advantage of elevated intrasector volatility in individual securities, a pattern they expect to continue and expand in 2018 as global markets normalize in response to expected fiscal tightening by the U.S. Federal Reserve Bank, and possible future tightening by the Bank of Japan and European Central Bank.

Hedge fund management companies are entering 2018 from a position of strength, thanks to strong securities selection.

"I'm excited about opportunities for hedge funds in 2018," said Kevin G. Russell, UBS O'Connor's New York-based managing director and chief investment officer.

He noted that "equity index returns were staggeringly good in 2017" and as equity valuations improved, a benign and supportive economic environment encouraged companies to take on more leverage and grow their businesses, but stressed he believes conditions will change in 2018.

Mr. Russell said equities are unlikely to repeat "the same magnitude of returns and valuation expansion as the markets transition from monetary policy support to fiscal stimulus."

He stressed fiscal policy changes, regulatory rollbacks and tax reform in the U.S. "should be a self-sustaining tail wind for active managers."

UBS O'Connor manages $5.4 billion in multistrategy hedge funds.

Putting the brakes on passive

Other hedge fund managers agreed with Mr. Russell that as U.S. equity and bond prices fall and investment returns decrease, flows into passively managed strategies will reverse.

"There is evidence that markets are trading more rationally and that flows into passive strategies have peaked. Active managers are beginning to do better," said Mark E. Kingdon, founder and CEO of global long/short equity manager Kingdon Capital Management LLC, New York.

"There's still a bit of a headwind for anyone trading short — it's expensive to short when the cost of capital is so low, but hedge fund managers will be well-rewarded for their shorts in 2018," Mr. Kingdon said.

Mr. Kingdon said the firm's portfolio managers are going into 2018 long on stocks that are the beneficiaries of the U.S growth economy such as:

regional and money center banks;

U.S. basic industrial companies with reasonable valuations that are experiencing a specific catalyst, like widespread restructuring across the chemical sector;

U.S. housing stocks that will benefit from rising employee wages in many sectors; and

companies in the U.S., Japan and China experiencing growth at a reasonable rate within technology sectors such as internet providers, artificial intelligence and cloud computing.

Short-side investments for Kingdon Capital include poorly managed retailers and U.S. real estate investment trusts.

Kingdon Capital manages $1.6 billion.

Credit hedge fund managers are optimistic about their prospects in 2018 but emphasized they will be looking for idiosyncratic investment opportunities across global markets.

"Given the end of quantitative easing in the U.S. and moderation of QE in Europe, I believe it's going to be a credit pickers' market in 2018," said Michael Hintze, CEO, senior investment officer and senior portfolio manager, CQS (U.K.) LLP, London, in the firm's annual investment outlook report.

"During 2017, we began to see growing dispersion within indices. While volatility at the index level remained low, there have been rolling pockets of stress at the sector and issuer level, noticeably in the U.S.," Mr. Hintze said in the report. In the rising interest rate environment going into 2018, he added, CQS portfolio managers "continue to favor shorter duration and floating-rate assets. Additionally, given global growth, sectors such as commodities ... should perform well."

Beneath the surface

Credit specialist Canyon Partners LLC. Los Angeles, will continue to look for "beneath-the-surface volatility" throughout global credit markets in the form of disruptions such as acquisitions, mergers and distribution activity, said Joshua S. Friedman, co-founder, co-chairman, co-CEO and co-CIO.

"There are relatively few areas in the credit market that stand out as being exceptionally target-rich right now. Markets are trading at pretty even levels which requires turning over lots and lots of rocks," Mr. Friedman said, pointing to sectors such as telecommunications, retail, energy and health care as good fields for investment opportunities.

Canyon Partners managers $24 billion in multi- and single-strategy credit-oriented hedge funds.

In response to institutional investor demand for private credit investments with very low sensitivity to public markets and little correlation with other fixed income portfolios, Magnetar Capital LLC, Evanston, Ill., is scouring global markets for idiosyncratic investments including European automobile loans, film financing and drug royalties.

Looking ahead at market conditions in 2018, David Snyderman, Magnetar's global head of fixed income said credit cycles usually end with systemic problems such as bad balance sheets or poor fundamentals, but noted the current cycle likely will end differently because there's more liquidity and stronger growth in global credit markets.

"We don't know when the current credit cycle will end but likely will be characterized by market disruptions from new technologies or distribution innovations along the lines of how Amazon transformed the retail sector," Mr. Snyderman said. "When this current cycle does end, there will be significant winners and losers and this is not yet reflected in the credit markets."

About half of Magnetar's $14 billion of assets are managed in the firm's private credit strategy.

Diversified credit hedge fund manager Ellington Management Group LLC took advantage of market changes in the past year that have made it easier to finance less liquid debt instruments, said Michael W. Vranos, founder and CEO of the Old Greenwich, Conn. firm.

"Long-term assets that now can be financed with securitizations or by Wall Street banks offer tremendous upside for hedge fund managers," Mr. Vranos said, noting that the firm completed several bank facilities in the past year of consumer and other loans, as well as securitizations of non-qualified mortgage loans, and first-lien leveraged loans through a collateralized loan obligation vehicle.

"The increased volume in less liquid credit instruments led us to create a hybrid private equity structure with a longer lock-up period and a greater focus on these kinds of opportunities," Mr. Vranos said, adding that his expectation is that market conditions in 2018 and beyond will remain favorable for illiquid credit investments.

Ellington manages $6.5 billion in a range of credit hedge fund and long-only strategies.