We may finally be seeing the light at the end of the tunnel. Quantitative easing has been a headwind for hedge fund strategies, with low rates and rising asset values making shorting difficult. When asset values rise with suppressed volatility, there are often limited downturns that present opportunities to capitalize on the short side. But with tapering of the Federal Reserve’s asset buybacks and a shift toward rate hikes, we are encouraged by potential opportunities across many hedge fund strategies.
2015 has been largely a year to forget for the majority of hedge fund managers and strategies. After a strong first half, a confluence of factors put the second half on track to perhaps be one of the worst relative performance periods in recent history. This was particularly the case for bottom-up, value-focused long/short funds and event-driven equity and credit strategies. As much of this difficulty was driven by non-fundamental, non-recurring reasons, as discussed below, the opportunity set for these strategies heading into 2016 appears stronger to us than it has for several years.
Long/Short: Is Weakness Morphing into Opportunity?
Market turbulence in August and September was triggered by weakness in China and subsequent growth concerns more broadly across the globe. While this was a small headwind for most hedge funds, the drivers of the third- and fourth-quarter challenges were, in our view, more idiosyncratic to the hedge fund industry itself. A portion of the underperformance appears linked to sector-specific bets which emerged throughout the year, predominantly in energy and health care. These areas suffered indiscriminate, across-the-board declines due to the fall in oil prices and political rhetoric, respectively. In both cases, the broad-based declines have provided fertile long/short stock picking opportunities that we believe could bear fruit regardless of the level of commodity prices or the likelihood of drug-price-related legislation.
Event-Driven: Crowding Headwinds and the Future
Perhaps the more noteworthy explanation for recent underperformance, however, has to do with a gravitational force created by the hedge fund industry itself. At nearly $3 trillion in size, hedge funds have seen considerable growth since the 2008 financial crisis. More recently, activist and event-driven funds have been the beneficiaries of considerable asset inflows. This capital has largely been put to work in companies undergoing some corporate event, such as mergers, asset sales, spinoffs and share buybacks, either initiated of the company’s own volition or, at times, induced by the hedge fund itself as a means to create greater value for shareholders. Success or failure of these positions tends to be dictated more by the consummation of the anticipated event than by broader market direction. That said, given that many like-minded hedge funds tend to gravitate to these non-market dependent situations, crowding can often occur. In most periods, this crowding is a non-issue. However, episodically these more heavily owned positions can suffer sharp, non-fundamentally driven selloffs precipitated by the need of one or more holders to liquidate positions for risk management or other business-driven purposes (e.g., a shift in strategy, meeting investor redemptions, etc.). This phenomenon occurred in the second half of 2015, with losses experienced by the “most crowded” hedge fund stocks exceeding the losses of the S&P 500 by roughly 15%.1
Market dynamics can change quickly, however. For example, the chart below shows that around December 2008, the most crowded hedge fund stocks faced a period of significant underperformance, but that shortly thereafter this was followed by a period of strong outperformance in 2009. A similar pattern occurred in October 2011. In our view, the recent underperformance of the most crowded hedge fund stocks was primarily a result of technicals rather than fundamentals. We believe that current idiosyncratic challenges are poised to fade and that well-researched, hedged event-driven names have the potential to rebound and managers that were not forced to sell could be well positioned heading into 2016.
Crowded Trades: Could Strength Follow Weakness?
Distressed: Ready for a Comeback?
After a quiet last two years, owing to low default rates and easy access to the capital markets for all but the poorest quality credits, we believe distressed debt hedge funds could make a comeback in 2016. The amount of bonds trading below 50 cents on the dollar is now greater than $100 billion based on total face amount, and the dollar amount of companies that have moved from investment grade to junk status year-to-date through November is more than in 2012, 2013 and 2014 combined.2 This material expansion of the stressed and distressed universe creates, in our view, one of the most attractive environments for the strategy we have seen since the onset of the financial crisis. While energy, shipping and other commodity-price-sensitive industries appear to represent the first stage of the cycle, higher interest rates and less open capital markets could put pressure on a broad range of companies as we move into 2016. This likely higher supply of stressed/distressed paper, coupled with less competition from investment bank proprietary desks, could bode well for hedge funds focused on the strategy.
Hedge Funds in the Broader Context
In the wake of a challenging year, we believe that it’s important to reinforce what we believe is the appeal of hedge fund strategies within the context of an overall portfolio. Over time, the asset class has the potential to reduce overall portfolio volatility and enhance one’s overall return profile. In our view, there were specific issues that contributed to 2015 being a challenging year; at this point, we believe that the environment is changing and that hedge fund managers should have more opportunities to add value in 2016.
1Source: Novus, based on quarterly 13F filings as of June 30, 2015. Performance data through October 14, 2015. The “most crowded” hedge stocks are as defined by Novus and reflect a basket consisting of the 20 stocks that have the highest percentage of their market capitalization held by hedge funds. Past performance is not indicative of future results.
2Source: JP Morgan Credit Strategy
This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types.
This material may include estimates, outlooks, projections and other “forward-looking statements.” Due to a variety of factors, actual events may differ significantly from those presented. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments. Investments in hedge funds and private equity are intended for sophisticated investors only. Diversification does not guarantee profit or protect against loss in declining markets. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
All information as of the date indicated. Firm data, including employee and assets under management figures, reflect collective data for the various affiliated investment advisers that are subsidiaries of Neuberger Berman Group LLC (the “firm”). Firm history includes the history of all firm subsidiaries, including predecessor entities.
This material is being issued on a limited basis through various global subsidiaries and affiliates of Neuberger Berman Group LLC. Please visit www.nb.com/disclosure-global-communications for the specific entities and jurisdictional limitations and restrictions.
The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.
©2015 Neuberger Berman Group LLC. All rights reserved.
