June was kind to macro hedge funds. They were up more than 3 per cent, in what was their best month since 2010, according to data from Hedge Fund Research, buoyed by long positions on the yen and – for the most fortunate – long on both the yen and the dollar, and short sterling.
Currencies and currency-related trades have been among the few bright spots for hedge funds recently (along with gold, which has risen more than 30 per cent since the end of 2015, according to Credit Suisse). Riding the yen and dollar up and taking on derivative trades, such as shorting Chinese companies that have lots of US dollar debt and dollar costs, have been among the few clear trends to follow.
But generally, these are challenging times for the industry both in the short and longer term. For most of the year and most hedge fund strategies, 2016 overall has not been great. “The world has turned into Japan,” says the head of one Hong Kong-based hedge fund. “When rates are this low, returns are low. There is too much money and too few opportunities.”
It is only slowly becoming conventional wisdom that rates are not going up soon anywhere. That means that the search for yield will become even more intense. The junk bond market in the US has been one beneficiary but now many investors are increasing their exposure to emerging markets, particularly in Latin America. “As everyone heads closer to negative rates, anywhere with yield is the place to be,” says a senior executive at one big investment group. “And that includes emerging markets.”
While developed markets continue to do everything in their power to make their currencies as valueless as those of the banana republics of yesterday, it is the emerging markets (EMs) that have proved to be more responsible stewards of their currencies – or at least they have been slower to erode their value.
Blackstone’s asset management group, for example, recently did a study of 90 major devaluations over the last 30 years and concluded that the worst is already over for some currencies that have recently gone through major devaluations including the Argentine peso and the Brazilian real.
“We expect EM to outperform developed markets for a number of reasons,” notes Ashmore in a recent piece of research. “EM technicals are good. Positioning is not at all crowded, because investors have broadly favoured developed market assets over EM assets since the Taper Tantrum of 2013. Absolute valuations in EM are attractive. EM net external balances are improving sharply thanks to competitive real exchange rates. EM countries are generally growing faster, have lower debts, better demographics, room to adjust policy and [are] more isolated from the DM political crisis.”
Moreover, “EM central banks have more room to act. Indonesia, India, Brazil, Argentina, South Korea, Russia, Taiwan, Singapore and China all have in common that they have room to cut interest rates in the future thanks to previous positive policy actions and low inflation,” Ashmore adds.
At the same time, there are strategies that may disappoint in this flat-to-negative-rate world. For example, the attractions of distressed asset investing, one of the strategies that looked particularly auspicious earlier this year, are rapidly fading. With rates so low, over-levered companies in the west, (with a few notable exceptions such as energy), can maintain their zombie status indefinitely as they have done now for two decades in Japan. There is
little growth and the anticipated recovery continues to remain elusive.
As for the longer term, disappointing performance may not be the biggest threat to the industry, with its 10,000 firms and $2.86tn of assets under management. As artificial intelligence continues to evolve, computers will not supplement managers, they will replace them. Automation is happening and as it improves with machine learning, firms like Blackstone are giving more money to quant funds.
Despite all their claims, some hedge funds are not nearly as diversified as they think they are, as correlations between different geographies and products and strategies increasingly converge. The quant investors can be far more diversified. They also use more leverage, but since it is spread over a greater number of positions, it is probably safer – and given where rates are, cheaper than in the past. Computers, moreover, have the advantage of not turning from investors to celebrities. Hedge fund managers, not known for their modest retiring nature, will have to learn more humility in the future.