Managers eye more return dispersion

Hedge fund managers and their investors could be rewarded with better returns in 2020 as volatility rises across global markets, fueled by uncertainty over factors including the impeachment trial of President Donald Trump, Brexit, trade wars, the outcome of the U.S. presidential election and less market liquidity.

These risk catalysts abounded in 2019 and the question going forward is which of these will pop up again in 2020 and when, said Kenneth J. Heinz, president of hedge fund index provider Hedge Fund Research Inc., Chicago, in an interview.

"These are highly polarizing, volatile issues. Global markets will price in the impacts of these possibilities and hedge fund managers will analyze all possible scenarios to prepare their portfolios,"

Executives at global macro specialist Brevan Howard Asset Management LLP, London, expect that "with equity markets at record highs … diversifying strategies such as macro (will) continue to be in demand" as investors face "a range of macro crosscurrents," said CEO Aron Landy in an email response to questions about the firm's 2020 investment outlook.

"Geopolitical tensions have been increasing, fundamental data on growth and inflation have generally been weak and there's significant uncertainty about the future path of monetary and fiscal policy," Mr. Landy said.

Brevan Howard managed $7.2 billion as of Oct. 31.

The recent escalation of attacks between the U.S. and Iran is unlikely to dramatically hamper hedge fund managers, sources said.

"Except for 2019, when the trade war between the U.S. and China caused implications for the global economy and company earnings, geopolitical events seldom impact the economy and earnings. Because of this, we do not see much risk of an impact to hedge fund investment on the back of the rising tensions between the U.S. and Iran," said Jordi C. Visser, president and chief investment officer of Weiss Multi-Strategy Advisers LLC, New York.

"If there was one place where it could have an impact in 2020, it would be in higher oil prices. The rise in tension comes at a time when the trend in oil is already higher," Mr. Visser said.

Weiss Multi-Strategy managed a total of $2.7 billion as of Nov. 30, of which $2.6 billion was managed in hedge funds.

The biggest catalyst in 2020 likely will be the U.S. presidential election if Mr. Trump loses, sources agreed.

"If Donald Trump is re-elected, investors can expect continued low rates, little regulatory change and a good environment for corporations and thus, also for credit. The U.S. market and economy will do well if he is re-elected. If a left-of-center Democrat is the winner, markets may get spooked quite easily," said Luke Ellis, CEO of Man Group PLC, London.

The same hedge fund strategies likely to do well in 2020, including systematic global macro, equity market-neutral and credit strategies, which attracted net inflows and performed well in 2019, likely will continue to prevail if President Trump is re-elected, Mr. Ellis said.

Man Group managed a total of $112.7 billion as of Sept. 30 in hedge fund, hedge funds-of-funds and alternative risk premium and other strategies.

Industry observers predict stronger performance in 2020 compared to the prior year for many hedge fund strategies as the tight correlations between asset classes that dominated in the second half of 2019 dissipate.

That said, 2019's aggregate hedge fund performance may be hard to beat given that it was the best in a decade, according to data from Hedge Fund Research Inc.

The one-year return of the HFRI Fund Weighted Composite index as of Dec. 31 was up 10.4% compared to a -4.8% return in 2018. The 2019 return is the index's best annual return since a 20% gain in 2009 calendar year.

The good news is that asset correlations already have begun to dissipate and "broadly speaking, there will be more dispersion between hedge fund strategies and hedge fund managers in 2020," resulting in more investment opportunities, said Jonathan M. Caplis, CEO of hedge fund consultant PivotalPath Inc., New York, in an interview.

Strong performance in 2019 is likely to continue this year for specialist hedge fund strategies, including single-sector, long/short activist strategies and region-focused funds, especially in Asia, said Joseph M. Marenda, a San Francisco-based managing director and hedge fund specialist in the pension practice of Cambridge Associates LLC, in an interview.

Sector-specific hedge funds that invest in areas including U.S. biotechnology, health-care, technology/media/telecommunications and microcap companies are "attracting a lot of investment attention from asset owners because of their outperformance, but since they are capacity constrained, many are closed," Mr. Marenda said. As a result, he said some of these specialty managers are launching long-only versions of their strategies.

Mr. Marenda and other sources said performance of industry-specific hedge funds likely will continue in 2020 because the in-depth knowledge portfolio managers have about subsectors they invest in helps them to find the best long/short opportunities and have conviction to concentrate investment in a small number of companies.

In the year ended Dec. 31, the HFRI EH: Healthcare index returned 23.4% — the best performer among all HFR indexes. And the 16.1% return of the HFRI EH: Technology index was the fourth-best performer.

Mr. Marenda declined to name sector-specialist hedge funds.

As for hedge fund firms, CEOs and chief investment officers said they see plenty of investment opportunities as they prepare their portfolios for more volatility and more dispersion.

For example, because investors have moved out of high-yield credit, credit specialist manager CQS (U.K.) LLP, London, is "finding opportunities created by this shift as it creates dislocations and mispricings. I prefer high yield on a selective basis over investment-grade (credit)," said Michael Hintze, the firm's founder, group executive chairman and senior investment officer, in an email about the firm's 2020 investment focus.

"With respect to the credit cycle, while we are closer to the end than the beginning, I do not believe it is over," Mr. Hintze said, adding "we believe compelling situations and distressed opportunities exist, especially in Europe."

Mr. Hintze also said that he expects the growing focus of investors on ESG factors will "increasingly affect valuations, (the) cost of capital and performance." He said CQS has embedded environmental, social and governance considerations into its investment processes and is managing ESG-focused strategies for the firm's investors.

As of Dec. 1, CQS managed a total of $19 billion. As of June 30, hedge fund assets totaled $6.3 billion.

In response to fixed-income markets that "remain volatile on account of a host of macro factors," credit manager Hildene Capital Management LLC, Stamford, Conn., is "focused on shorter-duration, high cash-flow-generating credit trades that provide intrinsic liquidity and can be redeployed into the widest spreads available," said Dushyant Mehra, partner and co-CIO, in an email.

"In periods of market stress, we are happy to take spread risk as (we) are getting paid to provide liquidity. A high cash-on-cash strategy allows us to play offense when spreads are widening out," said Mr. Mehra.

Hildene Capital managed a total of $9.3 billion as of Oct. 31, of which $2.6 billion was managed in hedge funds.

Weiss Multi-Strategy Advisers' Mr. Visser has a contrarian view regarding the impact of macro factors on global markets.

"2019 performance was driven by macro factors such as central bank stimulus, fear of recession and lower rates and trade wars. 2020 will be driven more by fundamentals. We're in a period of pause now and we think there will be a significant reduction in the impact of macro factors going forward," Mr. Visser said in an interview.

The firm's No. 1 theme in 2020 is the continued unwinding of globalization and exploiting the "huge differential between winners and losers" among corporations as global supply chains break down on both a long and short basis, he said.

Liquidity is the "greatest fear" so far this year at volatility specialist Capstone Investment Advisors LLC, New York, said Paul Britton, founder and CEO, in an interview.

"There have been dramatic changes over the last 12 to 14 months in market liquidity and there was a big drop in the fourth quarter of 2019. There wasn't sufficient liquidity to perform some basic market functions like repo (the Federal Reserve's repurchase agreements). Illiquidity will be a significant factor in the markets throughout 2020 because there aren't any regulations to address the issue," Mr. Britton said.

"Liquidity will drive volatility in 2020 and the volatility tails in the liquidity markets will be larger and more frequent," Mr. Britton added.

Capstone is defensively tweaking its asset allocation by moving out of strategies employing leverage to make sure the firm's portfolios have sufficient liquidity, he said.

"The more important question is how we can profit on behalf of our clients from the view that liquidity will be challenged in the 2020 environment," Mr. Britton said, noting that Capstone's investment teams are adding strategies that are long liquidity such as statistical arbitrage and various derivative-based dispersion strategies.

Capstone managed $6.1 billion as of Dec. 1.