Alternatives: Back To Playing A Supporting Role
January 2023
The HFRX Global Hedge Fund Index, our preferred barometer for broad liquid alternatives performance, posted a -0.6% monthly return in December relative to a balanced portfolio’s (50% stocks and 50% bonds) return of -3.11%. For 2022, the excess return for the HFRX Global Hedge over a 50/50 portfolio was 11.8%, highlighting the potential drawdown benefits of implementing alternatives within a portfolio of stocks and bonds during periods in which correlations rise. While the magnitude of alternatives outperformance relative to traditional asset classes is likely to moderate, the prospect of a rising CBOE Volatility Index, or VIX, from current subdued levels, combined with elevated monetary policy uncertainty on a global basis present a compelling argument for additional diversification.
At the strategy level, contributors to the HFRX Global Hedge Index during December included some of the usual suspects able to exploit downturns in risk assets, specifically, equity market neutral and merger arbitrage strategies. Merger arbitrage funds could be constrained by a more onerous regulatory backdrop for mergers and acquisitions (M&A) but investors are being well compensated for the possibility that deals break as acquisition premiums are at two-year highs. Merger arb also benefits from higher short-term rates and the potential for increased year-over-year deal volume as CEOs consider acquisitions to combat earnings/margin compression. The backdrop in December proved too choppy for systematic trend strategies using longer-term signals, as we observed sharp, short-lived shifts across asset classes, specifically commodities and currencies, during the month. Systematic managers could continue to give back some of 2022’s relative performance in a trendless market, reinforcing our desire for consistency over excess returns when evaluating trend following strategies.
Going forward, defensive strategies could take a backseat to areas most depressed in 2022. Convertible arbitrage comes to mind as annual issuance approached a ten-year low in 2022 and led to a limited opportunity set that could revert should serial issuers return to the market for financing needs. Hedged equity could also see renewed interest coming into the year as an appealing risk-conscious way to put capital to work for more apprehensive investors. While we expect alternatives to shift from what proved to be a leadership position in portfolios last year back to their historical supporting role in the coming year, the volatility dampening and drawdown limiting benefits of the asset class remain appealing to us.
