Reprinted with permission from HFM Global
There are no words to fittingly describe 2020, and we still have another quarter to go. Investors faced obstacles, both large and small, all year, from rising tensions with China, US election campaigns, political turmoil, social unrest, natural disasters, Brexit and others we are surely excluding. All, of course, were topped by a pandemic that shutdown the global economy in frighteningly short order, disrupted what we knew as the normal way of life, and threw global markets into disarray. Zoom has become a verb rather than a noun, and the historical way of conducting business may be forever changed.
It can be argued that capital markets have ignored reality following a period of extreme volatility and dislocation across asset classes. Both the bulls and the bears make strong cases for their views of future market direction, but only time will tell the true story. The bi-polar nature of how markets have priced in risk can be seen in banks and high-yield bonds. The former is trading with an impending credit disaster and the latter as if default rates will be cut in half. Both cannot be right.
Where we were
Allocators’ reactions to Covid-19-led market gyrations have been very interesting. Some tried comparing the initial period in early March to the Great Financial Crisis. From the top down, this would have been an accurate assessment as asset prices appeared to have no floor. The speed and magnitude of the down draft caught many off guard.
In contrast to the 2008 experience, however, the lack of excessive leverage employed on each side of the trade enabled fund managers and those invested with them to remain nimble and seek out opportunities to add exposure during that time. There appeared to be no herd mentality, contrary to 2008, when many exhibited similar biases, issues and concerns. This dynamic led to some admirable pockets of performance and enabled allocators to be actively engaged with new opportunities during this stretch. In mid-March through April, the conversations were quite positive from a hedge fund portfolio perspective, as allocators realised their hedge fund portfolios were acting in a manner consistent with what they had hoped for during other market drawdowns, with the notable exception of segments in fixed income relval and arbitrage strategies. This provided the impetus to firms to switch to an offensive stance rather than a presumed defensive mode.
Many investors came into the quarter with some dry powder, which helped dampen the overall drawdown and allowed for the thinking to switch to putting money to work in dislocated areas. Structured credit and distressed, particularly, caught the attention of firms, who were quickly engaged figuring out how best to articulate the trade that presented itself. Larger hedge fund firms quickly set up vehicles to raise money for such opportunity. Other incremental dollars allocated went to funds that were already in portfolios and funds where diligence had already been undertaken. In both scenarios, given the speed required to put money to work and the lack of any in-person interactions, capital went to familiar faces. Once the central banks stepped in, many opportunities in credit swiftly snapped back to normalised prices. The perceived distressed cycle that many predicted would come due to the economic dislocation, no longer seemed imminent. Passive equity investments or actively managed long-only allocations aimed to take advantage of the equity market drawdown.
In late spring and into the summer, an air of complacency had set in. This can be blamed on portfolio performance as much as human psychology, without the ability to meet new ideas in person and markets snapping back to pre-Covid-19 levels and beyond, vacation mode set in. The portfolio performance aspect played a significant role, however, in the slowdown experienced. This mindset can be titled, “Asset allocation renders manager selection obsolete”. An over-riding theme we observed from single and multi-family offices was complacency in new due diligence fueled by a Covid-19-related anomaly with respect to asset allocation. For the first time ever, a major market drawdown was paired with the inability to vet new managers. Thus, instead of new manager decisions, family offices used dry powder to reallocate to beaten down equity exposure buckets as well as to dislocated credit buckets with existing or familiar managers, or via drawdown funds already in place. In almost all cases, these default decisions proved fruitful given the sharp snapback in equity and credit markets. Despite the challenging environment for due diligence, the unprecedented asset allocation success gave investors further reason to not be in a hurry to vet new funds.
Where we are
With summer coming to an end, allocator activity will likely pick up from what turned out to be a more pronounced seasonal slowdown in August. Though allocator trend(s) are difficult to identify in the current environment, it’s clear that institutional investors have put in place virtual operational due diligence plans. In person investment due diligence remains difficult, and for some a hurdle that cannot be cleared. Family offices remain a case-by-case basis. Many family offices operate with a multi-generational viewpoint and do not see any urgency to put new capital to work when valuations are extremely rich and due diligence is difficult. With university endowments as well as family offices, cash remains a concern. The universities have blurred budgetary needs and likely constrained revenue streams that may require buffers provided by the endowments. Family offices that run diverse portfolios often own operating real estate and/or operating businesses and are holding cash with the expectation that those assets will require cash infusions.
Within equity long/short, healthcare specific strategies remain a key focus with biotech seeing a lot of attention. It is not uncommon for a family office or institutional investor to have multiple line items in healthcare strategies within the aggregate portfolio given the multi-dimensional aspect of the sector driven by a top-down view of a cyclical growth trend. Directional strategies are garnering more interest here than hedged.
Although an overall satisfaction with hedge funds was apparent, certain foundations have become disenchanted with the larger multi-strategy firms that took the brunt of the downward pressure and failed to capture the rebound. Dollars are being transferred from these strategies to the long-only or long-biased equity portfolios that have demonstrated an ability to produce sustained alpha over a relevant benchmark.
Interest in credit strategies appears to have tailed off. Many of the dislocations have traded back to intrinsic value and what is left are opportunities most investors would not want to own.
Where are we going?
The prevailing view holds that due diligence levels on new funds will start to uptick. Natural due diligence cycles, on average, take 6–8 months. We are closing in on month seven of the pandemic, so it’s likely that pipelines have been worked over. Funds that had face-to-face interaction with allocators either remain on the watchlist, have received allocations, or been set aside. Replenishment of the pipeline must occur, and we expect to see this through year-end. Natural portfolio turnover will also take place. Although generally pleased, not all funds performed in line with expectations. Fund allocations at risk are those that performed worse on the downside in March than would have been expected, even if they have regained or exceeded, investors high-water marks will be focusing on drawdown periods to substantiate a place in the portfolio. Also at risk are firms who have a dominant university endowment LP base where cash is needed, and hedge funds do fall in the liquid bucket. Lastly, firms who have done extremely well for their LPs can see some redemptions from longstanding investors as they look to monetise some gains.
A second down draft in the markets is expected by some in allocator community and they are sitting on dry powder to deploy when appropriate. If that happens, expect longer biased equity as well as passive equity strategies to receive inflows. In the longer-term, allocators do have their eyes on distressed, though the overarching feeling currently is a lack of urgency to get invested.
Investors will continue to focus on unique pockets of opportunity within asset classes or strategies that are less picked over by the general public. Niche strategies will continue to be in demand, strategies that can offer a low correlation of returns to a long-only equity portfolio and diversify overall portfolio risk exposures.
Lastly, the trend toward small to midsize fund managers should continue. Returns analysis continue to demonstrate newer emerging managers ability to outperform their larger established peers.
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