US 2020 Election Investment Pulse: Time for Strategy Rotation
Global equity markets rallied on Monday after major networks declared Joe Biden the winner of the US presidential election, and early analysis of a COVID-19 vaccine from a large US drugmaker showed promising results. Our Head of Equities Stephen Dover joined Brooks Ritchey of K2 Advisors to discuss what these two events could mean for certain commodity, currency, equity and fixed income markets, particularly in the United States and emerging markets. They also take a look at why “rotation” is the word of the week for many of K2’s hedge strategies.
Here are a few highlights from the conversation today:
- “One new theme you’ll hear us talking about in equity long/short, as well as in macro, a lot of the managers are looking outside the US. They’re looking at some of the Asian currencies. They’re looking at some of the emerging market fixed income areas.“ – Brooks Ritchey
- “Once you get the stimulus wearing off a bit, then you get back to corporate fundamentals. You get back to maybe a lagging scenario involving delinquencies, defaults and even bankruptcies.” – Brooks Ritchey
- “We get the sense from talking to the [hedge fund] managers that they’re going to let this rally run for about five more weeks. Around mid-December, the talk is they’re probably going to see most of the good news priced in, whether it’s a vaccine, whether it’s earnings growth from third-quarter reports. And they’re going to start to rotate.” – Brooks Ritchey
- “Certainly some incredible news today about the possibility of a vaccine. It’s probably positive for value stocks relative to growth stocks, and just positive for the equity markets in general, and perhaps positive for some rotation in markets outside of the United States.” – Stephen Dover
Stephen Dover: Very big news this morning from Pfizer about the vaccine for COVID, very positive results. The market has moved a lot.
It’s my great pleasure today to be able to talk about a whole category of assets, hedge fund assets and how they’re positioning themselves for the election, but also for COVID. Today, we have with us, Brooks Ritchey, who is the senior managing director of K2 alternative investments. Welcome, Brooks.
Brooks Ritchey: Yes. Thank you, Stephen. I don’t know, what it will look like in six months, but for now we’ve basically got maybe a year’s worth of returns going on in the last two weeks. The question we’re getting already is, is this good news for hedge strategies?
Stephen Dover: We absolutely want to talk about that, but a very broad audience here. So maybe just talk in general about why people include hedge strategies in their portfolios?
Brooks Ritchey: Yeah, sure. So it’s quite interesting because hedge strategies are actually complementary. They’re very much of a diversifier for a lot of the registered investment advisors, a lot of our institutional clients that hold a lot of Treasury bonds. So it’s really sort of a complement to both stocks and bonds, but the primary diversification, the negative correlation that we see in hedge strategies and hedge fund allocations is the diversification effect, vis-a-vis Treasury bonds and even some corporate bonds. There’s a bit of a misnomer out there in terms of hedge funds performance relative to equities. Hedge strategies are not necessarily supposed to outperform equities. Equities are beta one. Equities have a volatility of 12 to 15, depending on the market environment, whereas hedge strategies have a volatility much closer to Treasury bonds, maybe between 4-6% of volatility and only about one-third the equity sensitivity. So, most of the time, hedge strategies end up somewhere between the stock performance and the bond market performance.
Stephen Dover: Now, of course, hedge funds have a lot of different meanings, and I know you divide hedge funds into four categories, macro-driven, event-driven, relative fixed income and long/short. Let’s break those down. Let’s just first go to macro hedge funds, which maybe you can talk a little bit about how they have been positioned rolling into the election. And I suppose, given the COVID news this morning, what issues they’re looking at and how that might change going forward. And then we’ll talk about the other types of hedge funds.
Brooks Ritchey: So, global macro CTA (commodity trading advisors), they tend to be quite nimble. They might react to a monetary policy shift. They might react to a geopolitical environment. They might react to any sort of set of headlines. So they tend to go risk on or long risk assets at certain points. They did come into the election a bit more bullish than historically was the case. They thought there might be some good prospects on the vaccine, maybe by year-end. Of course, we got good news this morning and they were bullish on recovering global growth. But it’s very important to remember macro CTA, they can shift, they can become quite bearish, quite risk off and go short equity markets. They’ll be long the Treasury bond market, if they feel a bit concerned about global growth and whatnot. So they did come into the election with a slightly risk-on bias. Some of them are looking for a slight uptick in reflation. I know that sounds a bit surprising to some, but inflation expectations have been ticking up. The Federal Reserve came out and said they’ll allow inflation to go above the 2% inflation target. They’re going to focus on average inflation rates, not a 2% cap. You’ve got a weakening dollar. A lot of our macro managers have been short the US dollar for four or five months. They’ve been long equity markets, not fully long. They had de-risked over the summer, but they’ve maintained a long equity exposure. And one new theme you’ll hear us talking about in equity long/short, as well as in macro, a lot of the managers are looking outside the US. They’re looking at some of the Asian currencies. They’re looking at some of the emerging market fixed income areas. So macro CTA, the takeaway is they’ll either be risk on or risk off. They tend to be nimble and coming into the election, coming into this week, they were quite positive on global growth. And I’m a bit worried about the US Treasury market.
Stephen Dover: If the macro funds have been very risk on over this last week or so, do you anticipate any changes? Will they continue to be pretty risk on, or now that the market has perhaps performed so well, do you see maybe there’ll be a little bit of a softening?
Brooks Ritchey: Well, the word of the week so far in our investment committee discussions is rotation. So to answer your question directly, we get the sense from talking to the managers that they’re going to let this rally run for about five more weeks. Around mid-December, the talk is they’re probably going to see most of the good news priced in, whether it’s a vaccine, whether it’s earnings growth from third-quarter reports. And they’re going to start to rotate. They’re going to rotate geographically. They’re going to hold, if not add to emerging markets, you’ve got a weak dollar. Some of them are looking at energy doing better, raw materials in general. Some of them are long aluminum. They’re long copper, China is growing. So the short story on forward-looking, is that, they’re going to probably de-risk a bit in the US and up risk offshore. A lot of buzz about emerging markets right now, Stephen.
Stephen Dover: Yeah, that’s interesting. And we’ll come back to emerging markets, but let’s go to the second category of hedge funds. Those are the event-driven hedge funds. How have they been positioned over these last few weeks and how might that change now with all the news coming out?
Brooks Ritchey: Event-driven are really managers focusing on mergers, acquisitions, dividend hikes, spinoffs—any sort of corporate event that theoretically is not dependent on the trend in equities or the bond market. Well, with the COVID striking in March, there was a pretty large slowdown in terms of merger-and-acquisition activity for all the reasons I’m sure everybody knows. It’s harder to merge with a company if you can’t visit them onsite and whatnot. So there was a slowdown in volume. That tends to sort of hold back event-driven managers that are focused on merger-and-acquisition arbitrage, right? They’re buying the company being acquired. They’re selling short the company doing the acquiring. The, deal volume picked up quite a lot in August. That’s good news. The not so good news is most of the event-driven managers, they need the deals to close and most deal closures take five to six months. Maybe we see more deals now that we’ve got a bit more clarity on the vaccine and whatnot. So for now they need these deals to close. But they’re definitely having a bit of a muted year so far.
Stephen Dover: Equity markets have absolutely taken off this last couple of weeks, with news around the election and news also around the vaccine today. But another category is relative value fixed income, and of course, fixed income markets have moved the last couple of weeks, too. So, talk a little bit about that category, how they’re positioned, and how that position might change going forward.
Brooks Ritchey: So you’ll hear some common themes when we talk about relative value fixed income, long/short fixed income, as well when we talk about equity long/short. The word of the week I already mentioned is rotation. And a lot of the fixed income relative value, long/short managers, they’re definitely rotating away from some of the strategies that have done well, thanks to the Federal Reserve buying high yield and some other debt securities. So as we get more fundamental clarity on balance sheets, on earnings, on who’s going to recover, sector by sector, you’re probably going to see more of a balanced book in a fixed income relative value. They’ll be long some securities that they like, but more and more, given the pressure on rates in general, and given them a theme of reflation, they’re looking at corporates, to hedge out market risk on the short side. A lot of good news is priced in. Now we see who can really recover and who can access financing and whatnot. Once you get the stimulus wearing off a bit, then you get back to corporate fundamentals. You get back to maybe a lagging scenario involving delinquencies, defaults and even bankruptcies. So that’ll be a great low beta long/short strategy, probably for the next six, 12 months.
Stephen Dover: So let’s turn to the other category and that is long/short equity. That’s got to be a very interesting category right now. How have those managers been positioned again, rolling into the election and what changes do they have and what are they seeing going forward?
Brooks Ritchey: So that’s definitely a risk-on sub-strategy. They tend to carry an equity sensitivity of between 50 to 70. So they’re driven a fair amount by equity trends. They did de-risk a bit in March, April, May, and they’ve been re-risking as we get more clarity and more central bank stimulus. That’s been a bit of a tailwind for them in terms of their beta exposure. The big conversation we’re having with our equity long/short managers is value versus growth and sector rotation in general. And about six or seven weeks ago, when we had that first pushup in some of the value sectors, we had the technology sector stall a little bit. They started to really ramp up the potential for a rotation away from growth but take a look at value. So, they haven’t fully implemented that theme. It’s more like a Q1 of 2021 type of theme, but I got to tell you, they’re definitely seeing a pickup in long versus short sector dispersion, fundamental variances between the winners versus the laggards, some of the value names, especially this morning and late last week, some of the lagging sectors. The airlines and the entertainment area, cruise lines are rallying. That type of valuation opportunity is probably going to drive performance for quite a while, because we’ve seen years of underperformance in some of these value tilted sectors. I would stress that as we enter 2021, it’s going to be more about a bit of a sector rotation, a factor rotation, even a geographical rotation. If active management is going to improve because of fundamental clarity and because of vaccines and massive, massive differences in valuations then hedge funds are double active. The managers, they’re looking for longs that are cheap, and they’re looking for shorts that are not cheap. So I think if active management can see an improved regime going forward, then double active, long/short management, alpha-driven strategies will do well.
Stephen Dover: A lot of the news in the market, of course, in addition to the election results, is how that would affect stimulus one way or the other. And of course, stimulus is needed because the economy is slowing down. The news this morning of the possible vaccine changes the story somewhat. Of course, the biggest stimulus we could possibly have is a vaccine that would reduce the path of COVID. And that’s incredibly positive news. It looks likely to be a rotation, very positive for a lot of value stocks, or as I like to say, those stocks that will benefit from the health coming back from the COVID crisis. Do you see your managers positioning to that?
Brooks Ritchey: Let’s call it a risk-on rotational Stephen, right? It’s a risk-on rotational. And I’ll add another rotation element here, I’m on record as feeling that hedge strategies and equity strategies will be quite competitive versus Treasury bond performance this year and next. So there’s no guarantees, but I got to tell you, I talked to a strategist two months ago, and I asked him point-blank, What would be the catalyst that finally gets the yield curve steeper? Finally gets the Treasury bond, off of two-year yields of 17 basis points—negative, real yields? And I asked him, what’s the catalyst? He paused, and he said one word. And you just said the word, Stephen: vaccine. That’s a game-changer. It’s probably not going to be fully adopted but it’ll change perception. And be careful on Treasuries. Treasuries are a nice inflation hedge. Treasuries are probably not where one’s going to generate yield or capital gains. But there is a rotation that is playable, a geographical rotation, factor rotation, sector rotation, and asset class rotation. So the word of the week is rotation, Stephen.
Stephen Dover: Well, thanks, Brooks. It’s been an interesting conversation and certainly some incredible news today about the possibility of a vaccine, It’s probably positive for value stocks relative to growth stocks and just positive for the equity markets in general, and perhaps positive for some rotation in markets outside of the United States. It’s been a pleasure talking to you, Brooks, about hedge fund strategies. Thank you very much.
Brooks Ritchey: Thank you.
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