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Will March Performance Prompt A Shake-Up Of Investor’s Hedge Fund Allocations?

The Covid-19 pandemic is currently causing chaos in financial markets, prompting some observers to examine which, if any, hedge fund investment strategies are providing downside protection and which, if any, hedge fund strategies are actually producing positive returns.

One such observer is Dr. Toby Goodworth, Managing Director, Head of Risk & Diversifying Strategies at investment consulting firm bfinance. On Friday, Goodworth published a research note examining a handful of hedge fund strategies, showing that there are some positives for investors which allocate to hedge fund products.

Goodworth points to discretionary global macro managers making significant gains from their rates books so far in March, and he says that some long volatility/tail risk protection strategies are up between +10 - +30%. In managed futures, long-bond and short-energy positions have been paying off for the trend followers – Goodworth cites the SG Trend Indicator’s month to date performance (up +25.83% at the time of writing) as well as the more realistic figure from the SG Trend index (up +1.71%) in his research note.

CTAs have been here before. In 2008, systematic trend followers – the bulk of the managed futures industry – produced ‘crisis alpha’ returns for their investors, and then proceeded to struggle to produce positive returns for much of the following decade, resulting in investors withdrawing money from these products and allocating to other strategies. Will investors now be more inclined to stick with CTAs instead of trading in and out of them, given their strong showings in times of severe equity market retreats? Goodworth’s not so sure.

“The interesting point about CTAs is that they do seem to have helped out when they are needed most. If you look at the volatility environment, the effects of quantitative easing means that the market has not been a CTA market. Many were long bonds, long equities and looked more like a risk parity fund. They’re more neutrally positioned now and the potential for CTAs is now greater than it has been. That said, some investors won’t use them, and some used them and no longer use them, and some use them and will continue to use them. But the CTA strategy as a whole is behaving as expected,” he said.

Regardless of which hedge fund strategies are doing well – or, at least, less poorly – perhaps a more interesting question, and one to which Goodworth alludes in his note, is that of whether the Covid-19 phenomenon, and its effects on markets and investing, will lead to a change in how institutional investors view hedge funds’ place in their broader portfolios. Goodworth explains that investor’s view of hedge funds is different to the one they had in the aftermath of the Global Financial Crisis.

“In 2008, it was a question of hedge funds not being able to survive from an operational standpoint. Now, it’s much more about pure performance and expected returns. There’s no issue with the survival of funds – it’s investors looking at whether the performance is in line with expectations or not”, he said. “Whenever you see these dramatic events, in the medium term, investors won’t knee-jerk react. They will use it as a learning point and say ‘maybe we didn’t have enough in this strategy or too much in that one. In more benign markets you can’t identify these as easily.”

Goodworth says that bfinance already analyses how managers perform navigating troubled waters, and that his conversations with clients about hedge fund strategies have, for a while, drilled down into the nuances of what managers are offering compared to the investor’s wider portfolio.

“When we look at managers, we have a durability analysis to see how they performed during distressed markets. When asset owners say to us ‘we need more in hedge funds’, we pick that apart more. Do you want convergent or convex strategies? Are you looking for directional strategies or market independent ones?”, he said.

These conversations and the analysis of just how hedge funds perform - in all market conditions - are sure to become more frequent and more intense in the coming months between investors, their consultants and their managers. Goodworth doesn’t go as far as predicting a dramatic shake-out of the hedge fund industry but he believes that investors will be making changes based on what they’re seeing from their hedge fund portfolios at present.

“You’re not expecting hedge funds to deliver huge positive numbers, but you’re also expecting them not to lose significant amounts of money. It’s important to point out that just because the strategy is producing negative returns, it doesn’t mean it’s broken. Inevitably, though, investors will look at March, and might say ‘I might not have had the right weightings.’ When the dust settles, as with 2008, new decisions will be made that will inevitably result in reallocations.”

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