Philippe Ferreira
Lyxor Asset Management

Lyxor Asset Management senior cross-asset strategist Philippe Ferreira explains how hedge funds have fared so far this year

How have hedge funds performed in 2016?

The hedge fund industry has had a tough start to the year as traditional markets have seen risk assets tumble. There has been an improvement recently but, overall, performance has been under pressure. This year we have observed a challenging market environment, with sustained volatility in equities and an expensive fixed income market. In the big picture, times are tough but not all strategies have suffered equally.

Which strategies were hit hardest?

Long/short equity managers have had more pressure than other strategies as the result of the frequent market rotations. When the markets were first down earlier in the year, some managers that had backed directional products suffered, but as the market rotated value funds rebounded and hedge funds were forced to be more cautiously positioned.

Long-short equity managers were hit by the market downturn in early 2016 and didn’t fully recover during the rebound because it happened in sectors that were most under stress, such as energy and materials, that a lot of managers weren’t exposed to any more.

How did the downturn hit short strategies?

A lot of hedge funds actually took a hit on their shorts, which turned out to be quite costly because they were building large positions in sectors such as energy, which had been suffering for a while but then recovered rapidly in mid-February, without much warning. As a result of that loss, there has been a dramatic reduction in the use of single-stock shorts, which some managers have since partially replaced with indices shorts. The move to indices tracking shorts shows that participants are really unsure about which specific stocks are going to move next and so are having to cast a wider net to try and capture profits.

Everyone was starting to be concerned about a possible recession and then suddenly the market delivered 10 to 12 percent in only four weeks in the most heavily discounted sectors. The market continues to normalise at present, which has been good news for long-short equity managers.

The strong recovery confused a lot of short sellers and because they were posting losses they had to consider changing their strategies, which some did, but most held their convictions. At present, our data seems to show that those who shifted their strategy to minimise losses are actually now facing headwinds from other areas, while those who maintained their positions despite the recovery are likely to be rewarded later in the year.

On the positive side, commodity trading advisors (CTAs) have had a great Q1 and, more recently, the long-short credit funds in Europe enjoyed market relief on the back of the European Central Bank’s (ECB) asset purchase programme.

Are managers largely optimistic for the future?

Yes, and we know this because we’ve seen managers adding risk to their portfolios, although only moderately. They are adding risk, while maintaining exposure to defensive sectors such as consumer staples, healthcare and telecommunications thanks to the fact that market conditions have stabilised over the past two months.

On the short side, there used to be a lot of equity strategies focused on energy and material sectors, but the rebound has caused some trouble for them and most participants have since reduced their positions in those areas.

How important is the use of algorithmic-based trading in the hedge fund space today? Is it widely used for short strategies?

In the industry today, you often see the managers that use algorithms most posting the best performance, so it’s very important and gaining traction. CTAs use algorithms for their entire portfolio and it drives their asset allocation decisions in both their long and short books. It was CTAs’ algorithms that led them to be aggressively short on the energy sectors in Q1 this year, but they often focus on futures trading, which are quite liquid, so they are able to remain quite flexible if the market shifts, which it did.

Was it a reliance on algorithms or a lack of liquidity that allowed managers to be caught by surprise when the energy market bounced back so quickly?

The rebound was caused, in part at least, by the US Federal Reserve adopting a dovish stance, along with the ECB’s actions in Europe, which then gained momentum as the biggest managers reduced their short positions and drove the trend onwards. There are some managers that focus on short-term trends are therefore able to reverse position much quicker, but these participants are small and it’s unlikely that they contributed to the rebound in any significant way. At the end of the day, it’s always very difficult to quantify if the hedge funds are the ones driving the market and starting trends.

How much of an impact does the low interest rate environment have on hedge funds’ performance?

It’s having a positive impact for participants involved in credit arbitrage, but a low or even negative interest rate environment is also a hurdle for many other managers simply because most strategies involve keeping cash on the books for liquidity purposes, although that means it’s suffering under low or negative rates.

Recently, we’ve seen managers turning to exchange-traded funds (ETFs) rather than futures contracts because the advantage of futures is that they are more economical as you don’t have to post 100 percent of the capital. But if that capital is sitting on your books with negative interest rates then there is no advantage. This has given rise to a growth in the market of ETF lending that wasn’t there before.

How was the market treated prime brokers during this period?

The main trend for prime brokers that we observe is a structural issue that leverage is more costly today. On the regulatory side, you need to post more capital in front of credit lines that fund the leverage of hedge funds, and that’s put pressure on them. We see some managers struggling to get financing, or who are having to pay more, and this impacts on performance.

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