2021 Market Preview Hedge Funds - Marquette Associates
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2021 Market Preview
Hedge Funds
POISED FOR ANOTHER RECORD YEAR?
In a challenging year filled with uncertainty and unpredictability,
hedge funds were a bright spot, performing exactly as
expected. Hedge funds helped protect capital during the
sell-off in February and March, participated in the recovery
off the bottom, protected again amidst the pullbacks in
September and October, and throughout the year helped
offset heightened market volatility. Hedge funds, as measured Joe McGuane, CFA
by the HFRI Composite Index, returned 11.6% in 2020, trailing Senior Research Analyst,
the S&P 500 up 18.4%, but with half the volatility. As a result, Alternatives
hedge funds saw record inflows in 2020 and exited the year at
peak asset levels.
As we look forward into 2021, we see a number of reasons to expect continued
market fluctuations and volatility. A narrowly Democrat-controlled government will
try to make strides in a sharply-divided country. Business leaders and policymakers
will manage against an unusual mix of early- and late-stage dynamics. Headlines will
continue to oscillate between COVID case numbers and vaccine progress. Against Jessica Noviskis, CFA
Senior Research Analyst,
this backdrop — and with equity valuations near highs and rates and spreads
Hedge Funds
near lows — hedge funds may be some of the best investments for 2021. Hedge
funds can improve portfolio diversification, reduce volatility, provide downside
protection, and in this environment may also be best positioned to play offense,
to take advantage of the windows of opportunity created by the uncertainty and
ultimately, generate top returns.
EQUITY LONG/SHORT
Equity long/short was the strongest performing hedge fund strategy in 2020. Long/
short managers, with the flexibility to be more opportunistic and generate alpha
on both the long and short sides of a portfolio, were especially well positioned for
the year’s volatility. Through March, equity hedge funds were down 13%, holding
up better than the S&P 500 down almost 20%. Through the pullback, managers cut
INDEPENDENT INVESTMENT CONSULTINGexposures, meaningfully reducing gross and net leverage, and generated strong short alpha. Funds were
quick to add exposure back for the rally and ultimately generated record levels of long alpha. All in, total net
alpha for global long/short funds in 2020 was the strongest in history.
Exhibit 1: Record net alpha generated in 2020
20%
18%
16%
14%
Net Alpha Added
12%
10%
8%
6%
4%
2%
0%
-2%
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Source: Morgan Stanley Prime Brokerage
While long/short stood out in 2020 for its uncorrelated returns, lower volatility, and downside protection,
the group may be even better positioned for what should be a strong stock picker’s market in 2021. For
most of 2020 the market was largely driven by macro factors — first the negative impact of COVID-19 and
the related shutdowns and then the prospect of a recovery. Stocks largely moved up and down as a group,
with idiosyncratic fundamentals less important. While macro factors will no doubt remain influential in 2021,
company-specific drivers and risks should begin to come back to the forefront. The COVID pandemic pulled
forward a number of developing trends that furthered the divide between the haves and the have-nots:
companies adapting to and excelling in new and changing environments versus those struggling to keep up,
resilient assets with valuations caught up in the panic versus wrongly-assumed or temporary beneficiaries
facing an eventual correction. Long/short managers are uniquely positioned to profit on all sides, and
managers with proven stock-picking track records should have a distinct and sustainable edge over passive
or more constrained managers.
Technology in particular will be a captivating space to watch in 2021. The tech sector is strongly suited
to long/short, marked by an unmatched pace of innovation and an ever-evolving universe of disruptors
and disrupted. The digital transformation was more accelerated by COVID than even the most bullish tech
managers could have predicted. Some stocks up several hundred percentage points are just scratching the
surface of their ultimate opportunity, while some up far less are already over their skis. The tech sector was
the strongest driver of long/short alpha in 2020 and many tech-focused hedge funds put up exceptional
numbers. Though it would be imprudent to expect a repeat, the opportunity long and short remains
considerable for thoughtful tech managers. Even to the extent a value rotation continues, investors should
feel confident that secular can continue to prevail over cyclical.
2Exhibit 2: Tech-focused funds have outperformed with less volatility than the broader peer group
30%
25%
20%
15%
10%
5%
0%
Return Standard Return Standard Return Standard Return Standard
Deviation Deviation Deviation Deviation
1 Year Annualized 3 Year Annualized 5 Year Annualized 10 Year
HFRI EH: Technology HFRI Equity Hedge HFRI Composite
Source: Hedge Fund Research
CREDIT
Exhibit 3: The search for yield drove exponential
Credit hedge funds ended the year in the green growth in higher risk credit markets
after a rough start. The first quarter of 2020 was
U.S. High Yield & Leveraged Loan Market Size ($B)
the worst for debt markets since the Global
$1,400
Financial Crisis in 2008. The quality of credit
markets had weakened considerably throughout $1,200
the most recent expansion, illustrated by the $1,000
charts in Exhibit 3, and as the uncertainties $800
of COVID took over, credit spreads blew out $600
and liquidity evaporated, sending assets
$400
across structured credit, U.S. municipal bonds,
$200
investment grade bonds, levered loans, and high 2007 2019 2007 2019
yield bonds sharply lower. Central banks stepped $0
U.S. HY Corporate U.S. Leveraged Loans
in with aggressive monetary policy actions and
Bonds
credit markets broadly rallied through the second
quarter. Investment grade and higher-quality BBB Rated U.S. Investment Grade Bonds
high yield bonds saw the sharpest rebound, 50% of IG
with the Federal Reserve providing substantial
quantitative easing via the purchase of both index $2.6T
3.9x
and single-issue credit. Lower-rated high yield
and distressed credit continued to lag through
the year, with businesses directly impacted by
COVID still under extreme distress. In structured
35% of IG
credit, while collateral loan obligation (“CLO”)
AAA tranches have fully recovered from their $670B
March lows, lower-quality tranches have yet
to recover (Exhibit 4) amid the unprecedented 2007 2019
wave of downgrades and the lack of support Sources: Bloomberg, Barclays, Credit Suisse
3from government buying programs. Commercial mortgage-backed securities (“CMBS”) also struggled as
delinquencies rose in the retail and lodging industries.
Exhibit 4: The percentage of CLO loans trading below $80 (a key threshold indicating distress) has
fallen considerably after hitting a peak of 29% in March
35%
30%
% of AssetsExhibit 5: Volatility risk premium corrected from the inversion earlier this year to above-average levels
40%
Implied Minus Realized Volatility
20%
0%
-20%
-40%
-60%
-80%
Nov-15
Feb-16
Nov-16
Feb-17
Nov-17
Feb-18
Nov-18
Feb-19
Nov-19
Feb-20
Nov-20
Aug-15
May-16
Aug-16
May-17
Aug-17
May-18
Aug-18
May-19
Aug-19
May-20
Aug-20
Source: Bloomberg. Implied Volatility, as measured by the VIX Index, minus Realized Volatility of the S&P 500 over the subsequent
1-month period (21 trading days), calculated as the standard deviation of daily logarithmic returns multiplied by an annualization factor
of the square root of 252.
MERGER ARB
Event-driven and merger arbitrage funds ended 2020 solidly positive after a rough start. The COVID pandemic
and related shutdowns slowed M&A activity and blew out deal spreads to levels not seen since the Global
Financial Crisis. While some deals did fail, many more prevailed and the corporate transaction market was
back to pre-crisis levels by the second half of the year. As we progress into 2021, there are many reasons
to expect M&A activity, and the opportunity for merger arbitrage funds, to remain high. There are high-
quality assets trading at discounted prices post the market sell-off. There are companies looking to bolster
growth or adapt business models for a post-COVID world. And there are private equity managers sitting on
a mountain of dry powder and other companies flush with cash after raising capital amid the pandemic, in
addition to the access afforded by low rates and a healthy credit market. Event-driven and merger arbitrage
funds can offer another layer of diversification for portfolios, especially if valuations are concerning.
CONVERT ARB
Convertible arbitrage was one of the best performing hedge fund strategies of the year, as this previously
sleepy strategy saw a renewed opportunity set. The perfect storm of heightened market volatility, near-
zero rates, and tight spreads backstopped by the government created the most compelling convertible
landscape in years. The new issue market hit an all-time high as both companies directly impacted by COVID
and desperate for cash as well as companies with pristine balance sheets looking to monetize the new
volatility regime turned to the convert market. Converts rallied from April on, with hedge funds in the space
putting up consistently strong returns post the Fed stepping into the markets. We expect the convertible
arbitrage opportunity to remain compelling in 2021 to the extent that interest rates stay low and market
volatility stays high.
5MACRO
Macro hedge funds on average ended 2020 in positive territory. While a number of funds were able to
capitalize on the year’s economic and political turbulence, others struggled. Equity allocations contributed
positively post the sell-off in March as central banks around the world stepped in to support markets. Rates
trading was also positive, as managers found opportunities long and short across the yield curve in the
U.S. and globally. Currency trading yielded mixed results amid the volatility created by rapidly changing
conditions across geographies. Emerging market credit positions were a drag on performance for most of
the year as certain countries were hit especially hard by the pandemic. From here, we expect performance
could remain volatile, as uncertain vaccine distribution shapes the path of recovery. Central bank activity and
the outlook for inflation and interest rates will be key variables for macro funds to navigate as the new year
progresses.
QUANT
Quantitative and systematic funds struggled in 2020. These strategies are based on traditional market
factors and historical market relationships that unsurprisingly did not deliver the same results in such an
unprecedented year. Is COVID a temporary departure from the mean or a more meaningful regime change?
Performance in 2021 will depend on the extent that market conditions return to more normal patterns, with
some funds — like the risk premia managers betting on value and size factors who underperformed both
before and after the rotation in early November — owing investors more of an explanation.
CONCLUSION
As the uncertainty of 2020 becomes the uncertainty of 2021, and as investors consider the implications of
equity valuations at highs and rates near lows, we recommend an allocation to hedge funds. Alternatives
play an important role in portfolios, especially when opportunities in traditional asset classes may be more
limited, and hedge funds have a liquidity advantage over private investments. We recommend institutional-
quality managers with a track record of generating alpha over an extended time period and across a range of
markets, who are tactical but stick to their knitting when tested, with reasonable fees and a strong alignment
of interests. These funds can help diversify a portfolio, reduce volatility, provide downside protection, and
improve overall returns, especially in periods of heightened uncertainty. We do not know what 2021 holds,
and that is exactly the point.
6PREPARED BY MARQUETTE ASSOCIATES
180 North LaSalle St, Ste 3500, Chicago, Illinois 60601 PHONE 312-527-5500
CHICAGO BALTIMORE MILWAUKEE PHILADELPHIA ST. LOUIS WEB MarquetteAssociates.com
The sources of information used in this report are believed to be reliable. Marquette Associates, Inc. has not independently
verified all of the information and its accuracy cannot be guaranteed. Opinions, estimates, projections and comments on
financial market trends constitute our judgment and are subject to change without notice. References to specific securities are
for illustrative purposes only and do not constitute recommendations. Past performance does not guarantee future results.
Marquette is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended.
Registration does not imply a certain level of skill or training. More information about Marquette including our investment
strategies, fees and objectives can be found in our ADV Part 2, which is available upon request.
About Marquette Associates
Marquette Associates is an independent investment consulting firm that guides institutional investment programs with a
focused client service approach and careful research. Marquette has served a single mission since 1986 – enable institutions
to become more effective investment stewards. Marquette is a completely independent and 100% employee-owned
consultancy founded with the sole purpose of advising institutions.
For more information, please visit www.marquetteassociates.com.
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