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Nimble, Shorter Term Hedge Fund Strategies Set To Outperform Amidst Market Uncertainty

Franklin Templeton’s fund of hedge fund division K2 Advisors published its fourth quarter hedge fund strategy outlook recently. Amongst its observations were that geopolitical events, such as the upcoming U.S. Presidential election, plus continued uncertainty around whether hard lockdowns will have to be re-imposed because of an acceleration in the spread of Covid-19, means that hedge funds are increasingly hedging their positions.

“All eyes are on a) the election, and b) the vaccine timeline,” said Brooks Ritchey, Co-Head of Investment Research and Management at K2 Advisors. “That said, we are seeing some continuing reduction in gross exposures and a slight reduction in net positioning. Some are adding to index short hedges due to the upcoming election. Others are taking profits in long positions and carrying cash in anticipation of heightened Q4 volatility. Interestingly, some equity long short managers are hedging against an increase in inflation by focusing on long positions that are correlated to Gold.”

Hedge fund strategies primed to deliver alpha in the coming months differ slightly, depending on who wins the election. Rob Christian, Co-Head of Investment Research and Management at K2 Advisors says that a Donald Trump victory should see opportunities for fixed income long short hedge funds and Ritchey says that a Joe Biden victory means that volatility arbitrage strategies should do well. Both Christian and Brooks say that discretionary macro and equity long short should do well regardless of who wins.

K2 Advisors has been bullish on equity long/short managers since the summer, partly due to the structural changes to the economy which have been accelerated by the effects of Covid-19 and partly due to the zero lower bound interest rate environment offering no options for poorly performing companies to refinance debt at a lower rate. U.S. Federal Reserve Chairman Jerome Powell’s abandoning of the hard 2% inflation target could see inflationary pressures building up in the U.S., offering opportunities for equity long/short managers.

“Any uptick in inflation also has a disparate impact on various equity sectors; especially if the U.S. Dollar weakens versus our major trade partners. Some companies will see their profit margins increase if inflation picks up. Others would be hurt by increased raw material costs. Additionally, if the US Dollar continues to weaken, companies purchasing parts and raw materials from outside the US might see margin pressures. On the flip side, exporting companies with international sales might benefit from a weak dollar as their foreign revenues can be converted in higher dollar amounts. The net effect is that if inflation rises (and/or the dollar weakens), hedge fund alpha and performance should improve as they go long those that benefit while hedging out market risk with short positions on those that are negatively impacted,” said Ritchey.

Inflationary pressures also provide opportunities for long/short credit hedge funds to shine.

“If the Fed is willing to let inflation trends run a bit higher than in the past, one may see higher interest rates and a steeper yield curve. Any companies with a need for ongoing debt financing may find it tougher to obtain credit at a reasonable yield. Additionally, if treasury bond prices decline, some investment grade and corporate credit instruments may follow suit and come under performance pressures. Thus, managers are noting that the Fed’s new FAIT [Flexible Average Inflation Targeting] policy may cause inflation expectations to rise and this might create additional opportunities on the short side,” said Ritchey.

Despite the current and potential tumult, K2 Advisors feels confident that its current portfolio of hedge fund managers can withstand what the next few months can throw at it; since the spring, despite the considerable structural changes to the world economy - however temporary they might be - manager churn hasn’t noticeably accelerated.

“The portfolio turnover has been within normal ranges since March of this year,” said Christian. “We feel our current strategy and manager weightings are positioned well for the forward-looking environment regardless of who wins the US presidential election and how long the COVID-19 health crisis slows global growth.”

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