Which Hedge Fund Strategies Will Work In 2014: Deutsche Bank's Take

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While January was a bad month for the market, it was certainly one which the majority of hedge funds would also rather forget as we showed yesterday. So with volatility, the lack of a clear daily ramp higher (with the exception of the last 4 days which are straight from the 2013 play book), and, worst of all, that Old Normal staple - risk - back in the picture. what is a collector of 2 and 20 to do (especially since in the post-Steve Cohen world, one must now make their money the old-fashioned way: without access to "expert networks")? For everyone asking this question, here is Deutsche Bank with its take on which will be the best and worst performing strategies of 2014.

So without further ado, here is the Deutsche Bank Asset and Wealth Management's forecast of hedge fund performance matrix:

Summary of key drivers for hedge fund returns

Below is a non-exhaustive list of market parameters that we believe drive hedge fund returns and our forecasts for these drivers.

What this means for a balanced hedge fund portfolio is set out below, with desired allocations in the penultimate column

We expect hedge funds will again outperform their historical average return in 2014.  Below, we set out our forecast for each strategy.

Equity long/short: Overweight

Our positive forecast for equity long/short is underpinned by our expectations of steady gains for equities and a helpful environment for stock-pickers, particularly as progress on tapering is priced into markets during the year. The latter will be a continuation of conditions in 2013, when correlations declined within equity markets and managers were rewarded for their research on individual company valuations.

In the US, we think equity markets will reflect company fortunes first and foremost, rather than macro and political influences – we do not expect a re-run of last year's Congressional stalemate. Overall, the Federal Reserve’s reiteration of its low interest rate policy should support growth and equity valuations.

We have a similar outlook for Europe, where the tail risk of a eurozone unwind has diminished markedly, the German election results support the future of Europe as a single entity, and signs of economic recovery are increasing. In emerging markets, we see more selective opportunities driven by individual country risk.

Equity market neutral: Overweight

Both factor-driven and statistical arbitrage managers should receive tailwinds in 2014. Factor-driven approaches should benefit from the improved stock-picking environment, as well as an increased focus on style and valuation factors by investors in more stable markets. Further support should come from the re-opening of new markets to the strategy (including Japan), as well as reduced capital in the sector, which should expand the opportunities for the remaining universe of managers. Statistical arbitrage managers should also benefit from a relatively uncrowded operating environment, as well as likely intermittent rises in volatility.

Discretionary macro: Neutral/Overweight

For some time this sector has been battling headwinds in the form zero interest rates and compressed FX volatility. We expect these to abate, especially during the second half of 2014, at last allowing managers to expand their opportunity set into interest rate and FX markets. In particular, the timing and pace of tapering in the US should offer opportunities for fixed income curve trading.

The contrast in the use of central bank balance sheets in the US and Europe throughout 2013 – expansion for the Federal Reserve, contraction for the European Central Bank – should create relative fixed income trading opportunities and, by implication, FX opportunities in 2014. Any change in ECB policy, perhaps sparked by the spectre of deflation, will increase volatility and return potential.

In Japan the reflation theme should continue to provide trading opportunities, while in emerging markets weaker economies more reliant on international capital flows should witness higher volatility in their exchange rates.

CTAs: Neutral/Underweight

We are marginally negative on medium-term and long-term trend followers in a portfolio context. CTA strategies will offer more for investors only when trends pervade beyond long equities. For now, long-term trends are likely to be in short supply in an environment of gradually rising equity markets, where the balance of returns is driven by stock-picking.

The Federal Reserve and other central banks are making greater use of forward guidance to try to head off sharp moves in risk assets. That said, some short-term strategies may benefit from the intermittent volatility we expect to see across certain asset classes.

Credit strategies: Neutral/Overweight

Despite current tight spreads and the potential for rising interest rates, we are constructive on credit. These headwinds are tempered somewhat by opportunities in floating-rate paper and higher convertible bond issuance.

Long/short credit strategies should benefit from the improved conditions for fundamental approaches, even though spreads are likely to remain unchanged. In this sector astute research by managers will be required, because many bonds continue to trade above par, limiting the upside against call risk.

There are opportunities for longer-term strategies in structured credit. These are supported by an improving US housing market and the potential for rising interest rates, which would reduce pre-payments and thus support mortgage derivatives. Meanwhile, higher equity markets have spurred new issuance in the convertibles market, creating opportunities in secondary markets.

Event-driven: Overweight

Event-driven strategies should continue to perform well. Activist managers should be able to derive opportunities from the significant cash piles on company balance sheets. For merger specialists, the potential for consolidation in the telecoms and materials sectors especially should drive increased returns. Similarly, we expect better performance for risk arbitrage and merger arbitrage managers on higher deal flow driven by company management teams' desire – or necessity – to increase return on capital.

Distressed: Underweight

The dearth of bankruptcies (both current and expected) will drag on returns for managers in this sector throughout 2014. Default rates are currently at a historically low level of 2.2% (compared to an average of 4.9%), and forecasts suggest they will remain muted throughout 2014. Debt maturities will not ramp up until late 2016.
Valuations remain full, with defaulting bonds and bank debt trading above long-term averages. The proportion of performing credit trading at either stressed or distressed levels is therefore also historically very low. As a result, there appear to be few opportunities – and significant money is chasing those that do exist, especially in Europe.

 

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Which probably means that in retrospect Distressed - that most universally panned of all strats - will likely be the winner. But then again, this is the New Normal, where nothing makes sense, and where groupthink is generously rewarded...