Tech Tremors Hurt L/S Equity
The recent correction in IT stocks led to a momentum reversal which impacted negatively L/S Equity funds, down -1.3% last week. Market Neutral L/S, which tend to be sensitive to the momentum risk factor, were not left unscathed by sector rotations. Overall, the Lyxor Hedge Fund Index was down -1% last week, with only one strategy in positive territory: Fixed Income Arbitrage. On a positive note, Event Driven was fairly resilient, down -0.3%, while Merger Arbitrage managed to outperform, up +0.2%.
The S&P 500 Information Technology index was down -4.1% in a week (from peak to trough), in a context of political brinkmanship on U.S. tax reform and in particular on the Alternative Minimum Tax (AMT). The AMT currently forces companies to pay a base level of federal taxes, meaning deductions and tax credits are capped. The repeal of the AMT, which was considered in the original Senate tax bill, is key for R&D intensive sectors such as health care and IT. They currently benefit from substantial tax credits. Yet, the Senate bill that was passed early December eventually maintained the AMT to contain fiscal deficits. Critically, the fact that the current AMT rate is about the same as the corporate rate considered in the reform (20%), means the effective tax rate would probably increase for such sectors. This contributed to drag IT stocks lower. In the hedge fund space, it translated into an underperformance of L/S Equity funds considering their elevated exposure to the sector.
Going forward, the AMT issue will need to be resolved by the conference committee that will work to merge the Senate and House legislation. According to Reuters, quoting the chairman of the U.S. Senate Finance Committee on Dec. 6th, the AMT will not survive in the final tax bill that could be signed into law by President Trump before year-end. That translated into a recovery of IT stocks over the most recent days.
Recent developments mean that Event-Driven returns took the lead over L/S Equity year to date. Even if we believe that Republicans will fix the AMT issue, implying that L/S Equity funds will recover, we maintain a preference for Event-Driven strategies. Merger arbitrage remains highly attractive in our view for protection (low beta) and risk adjusted performance (current deal spread stands at 4.3%) purposes.
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