Clearbrook: Skip long biased and merger arb managers and invest in macro, emerging market and market neutral hedge funds

January 25, 2012  

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Pension consultant Tim Ng explains which strategies will perform best in 2012.

   Tim Ng

Due to the market uncertainties that abound in Europe and Asia, along with the political impasse seen in the U.S. and social unrest in the Middle East, the global economic outlook is mixed.

On the positive side, global monetary conditions will likely ease in order to foster economic growth. The European Central Bank, Bank of England, and various emerging market central banks are likely to make use of their printing presses. The Eurozone is expected to be in recession going into 2012, with moderate growth expected in the years ahead. Business and consumer confidence is weak in Europe as expected due to the financial market stresses. As such, capital formation remains weak as well as private consumption.

U.S. growth should come in around 2.5% as real consumer spending has increased. There should be continued increases in manufacturing output and improvement in employment as witnessed by the recent decline in jobless claims.

When looking at China and emerging Asian countries, we do not foresee a hard landing, but a soft one with GDP growth in China slowing from 9.1% in 2011 to 8.1% in 2012. The continued growth in Chinese domestic consumption and easing monetary and fiscal policies should help GDP growth remain on a positive trajectory. Emerging Asian country growth remains positive in India, Malaysia, Thailand, and Philippines, bolstered by resilient domestic demand.

Despite those positive signs, hedge fund returns in 2012 will be reflective of a mixed market environment. Risk aversion still characterized markets early in the year, but we expect a divergence of global growth later in 2012. Strong growth in emerging and developing markets will combine with recession in Europe and slow growth in the U.S. and Japan. As such, we believe asset valuations in 2012 may be driven more by fundamental than macro factors, but we expect market volatility to remain higher than normal with the potential for downside drafts. Another theme is the investor search for yield as short rates continue to be negative in real terms.

So, which are the hedge fund strategies to pick? First, we like market neutral long/short equity investing as we expect greater divergence and lower correlation of stock prices in 2012. And for stocks, we also like managers that invest in emerging markets. They performed poorly due to capital flight in 2011, leaving such the markets with low valuations. Combined with monetary policies to foster growth, emerging market stock prices should recover. Emerging market debt is also attractive based on higher yields, stronger credit worthiness and the values of emerging market currencies versus those of developed countries.

For developed markets, investing in high-yield corporate bonds is a good alternative as sovereign debt is priced to perfection, and money market alternatives are providing negative real yields. Default rates continue to remain low and corporate balance sheets are strong and still retain a great deal of cash on hand.

After a difficult year, global macro managers should recover as themes in currencies, commodities (energy and metals), and interest rates should have greater visibility in 2012, providing good trading opportunities.

We also like options-based strategies. They can both enhance yield via the sale of covered call options or the combined use of short call and long put spreads to hedge downside equity market risk while offsetting a portion of the downside protection cost. In addition, we favor strategies that are long volatility as it will spike dramatically in a market downturn. The firm is also in favor of strategies that can take advantage of widening sovereign debt and credit spreads, either in the form of CDS or straight short debt positions.

And which hedge funds strategies should be avoided? Strategies that will be out of favor include long-biased long/short equity, as we foresee equities markets will be subject to bouts of volatility and thus downside risk. Merger arbitrage is also risky as deal spreads are subject to not only idiosyncratic but also market risk, and we believe the present overhang of global economic and political uncertainty will cause so-called CEO paralysis and the number of deals that will transpire will leave a lot to be desired. Also, distressed debt could be confronted with tail winds as any de-risking phase will cause bouts of illiquidity and cause spreads to widen.

Clearbrook has been working with its clients to incorporate hedge funds in order to decrease the amount of equity beta or volatility (or both) in their portfolios. In addition, we are looking at hedge funds to provide yield alternatives to traditional fixed income investments due to their low to negative real yields, as well as the eventual duration and interest rate risk that will come.

Timothy Ng is a managing director at investment consultant Clearbrook Investment Consulting

See also: 
2012 Investor Outlook: Huge disparities, no shift to small funds


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