Hedge fund managers see chance to cash in on volatility

Broadly held expectations of a more volatile investment environment in 2019, characterized by a return to fundamentals, will give hedge fund managers a much-needed comeback opportunity this year.

By nearly every measure, hedge fund managers, in aggregate, endured an awful year in 2018.

The HFR Fund Weighted Composite index was down 2% year-to-date through Nov. 30, on track to produce the $3.2 trillion industry's worst annual performance since the index fell 5.25% in 2011. Hedge Fund Research Inc. produces the HFR index family. Data through the end of the year were not available at press time.

"2019 is an important year for hedge funds. Over the last eight to 10 years, capital markets were up and to the right, a suboptimal environment for hedge funds," said Eric Costa, managing director and global head of hedge funds at investment consultant Cambridge Associates LLC, Boston.

However, "rising volatility, lower correlations and higher dispersion mean that the year is setting up nicely for hedge funds," Mr. Costa said.

He noted that while long/short equity managers may be in for "at least one or two rocky quarters," managers of event-driven, quantitative and global macro hedge funds likely will do well in the new year.

More specifically, the combination of rising yields, tightened liquidity and heightened risk across global markets in 2019 will benefit managers running hedge funds with equal ability to go long and short, said Robert Prince, co-chief investment officer of Bridgewater Associates LP, Westport, Conn.

"We've been in a great market for the past nine years that benefited long-oriented managers because many assets did very well in an environment of falling yields, quantitative easing and good growth," Mr. Prince said, noting the reversal of those conditions makes it much harder for long-biased managers but is "an opportunity to demonstrate skill for strategies that do not have a long bias."

Bridgewater manages a total of $160 billion, $130 billion of which is in hedge funds.

Specialist credit manager Michael W. Vranos, founder and CEO of Ellington Management Group LLC, Old Greenwich, Conn., warned that 2019 will be characterized by a lack of market direction in equities and bonds, forcing hedge fund managers to focus on fundamentals.

"Choosing the securities with the best relative value and insulating them from major market risks is important as we move from quantitative easing to quantitative tightening," he stressed, noting that providing liquidity and active trading will "continue to be winning credit strategies in 2019."

Ellington manages $7.5 billion in hedge funds, with a focus on structured credit strategies.

Executives at Cheyne Capital Management (UK) LLP, London, which manages $6.5 billion, are looking forward to exploiting increased dispersion in global credit markets, said Stuart Fiertz, co-founding president and director of research.

"The market will become more thoughtful and discerning and that will create room for skilled credit managers to find opportunities," Mr. Fiertz said.

European banks are being forced by regulation to acknowledge losses on loans, and Mr. Fiertz said as these banks come under pressure to shrink their balance sheets, many likely will begin to shed their distressed but functional corporate loans, providing a good buying opportunity.

Cheyne recently staffed up with the addition of 10 credit specialists to take advantage of the situation, Mr. Fiertz said.

Long/short equity manager Lee S. Ainslie III, managing partner of Maverick Capital Ltd., New York, believes odds are growing that a "toxic soup" will develop in 2019 year as rates rise, the economy slows and corporate operating margins shrink.

"It may be very difficult to make money" in 2019, he said.

Volatile market environments, however, are helpful for long/short equity managers and greater dispersion between stocks and fewer artificial constraints in the form of quantitative easing means "alpha generation should become easier," Mr. Ainslie said.

Net exposure to the market in Maverick's core long/short equity hedge funds is at the low end of the range, Mr. Ainslie said, hopefully making them "well-positioned for 2019."

Maverick manages $10 billion in hedge funds.

Volatility manager Capstone Investment Advisors LLC, New York, has attracted significant attention from institutional investors to its equity volatility strategies since a spike in volatility last February rocked markets, said Paul Britton, founder and CEO.

Capstone manages $6 billion, $500 million of which was raised in 2018, Mr. Britton said, as institutional investors sought to position their portfolios to protect them as volatility rose in markets to what he described as more normal levels.

"Low returns with high volatility is not good for investors. Investors are looking for defensive strategies, which also produce alpha from buying volatility," Mr. Britton said.

"2018 was all about the U.S. equity story" when it came to volatility, Mr. Britton said, noting that volatility in 2019 more likely will come from Europe and Asia.

Institutional investors are heeding widespread warnings about likely dangerous market conditions in 2019 from a wide swath of market pundits and economists, and many are relying on hedge funds for downside protection and alpha generation.

"Most institutional investors are not getting out of hedge funds, although they may be reviewing their managers and portfolios. October was a wake-up call to investors when the S&P 500 was down 8% in a month," said Andrew Allright, CEO of InfraHedge Ltd., London, a hedge fund managed accounts provider.

"When the bull market turns and markets turn more to fundamentals, investors will turn to active management, specifically hedge funds, as they recognize that they need hedge funds for downside protection," Mr. Allright said.

Given the propensity for institutional portfolios to have an extreme long bias and high equity allocations, Bridgewater's Mr. Prince agreed that asset owners are seeking protection and diversification through hedge fund strategies that reduce risk.

"Hedge funds are particularly useful now if they have the ability to go short as well as long because they can reduce risk and produce alpha. They will be very beneficial in institutional portfolios in the coming environment because they can reduce portfolio risk and add diversification," Mr. Prince said.

For many asset owners, hedge funds' ability to produce alpha is as important or more so than their ability to offer a cushion in downside markets.

"The need for alpha has never been greater and it drives investor action. Asset owners are very keen on finding alpha sources and managers who can produce it," said Luke Ellis, CEO of Man Group PLC, London, a hedge fund and hedge fund-of-funds manager with $114.1 billion under management.

Although institutional investors generally are not reducing or getting out of hedge funds, they are actively upgrading their rosters of hedge fund managers in search of alpha producers, sources said.

Other asset owners are reducing the number of hedge fund managers in their portfolios, said Stephen Siderow, co-founder, co-president and partner at BlueMountain Capital Management LLC, New York, which manages $20 billion in hedge funds and other alternative investment strategies.

"Asset owners are consolidating their investments and are giving more capital to fewer managers and are getting advantages of scale including more concentration in favored strategies, early investment in new strategies, lower fees in exchange for longer-duration investments and development of an intellectual partnership with their managers," Mr. Siderow said.

Overall, InfraHedge's Mr. Allright said he expects there will be "enough investors, especially institutional investors, and enough cash" to push hedge fund industry assets up 20% to 25% from its current peak of $3.2 trillion over the next three to five years.

"I don't see the hedge fund industry running out of gas, but managers need to produce performance, which has been underwhelming in the past couple of years," he added.