by Justin Lenarcic Senior Global Alternative Investment Strategist
Every few years, capital markets have experienced a transformational event that directly affected hedge fund strategies. From junk bonds to collateralized loan obligations (CLOs), exchange traded funds (ETFs) to server colocation, technology and creativity have combined to create a new “regime” of opportunity for active management. Rarely, though, have we seen years in which investment innovation coincided with a significant change in the macro trading environment. 2020 was such a year. Not only did we witness a new equity volatility regime, but we also witnessed the maturation and adoption of Special Purpose Acquisition Companies (SPACs). While seemingly unrelated, we believe both will have a meaningful impact on hedge funds and likely usher in — the potential for compelling opportunities for arbitrage in 2021 and beyond.
The classic definition of arbitrage is simultaneously buying and selling similar or related securities, seeking to profit from potential mispricing in those securities while mitigating downside risk. If one takes that simplistic concept and applies it to capital markets, it’s easy to see why arbitrage can be an important tool within a hedge fund manager’s toolbox. Whether it’s fixed-income arbitrage (which seeks to capture small differences in global interest rates and yield curves), statistical arbitrage (which uses quantitative models in an effort to capture the tendency of securities to mean revert), or merger arbitrage (which trades the deal spread for mergers and acquisitions), we believe there is potential for an abundance of opportunities to capture mispriced securities while mitigating downside risk. But the one critical ingredient for successful arbitrage is mispriced securities. And what help cause mispricing? Volatility!
Higher equity volatility regime still in place
Sources: Bloomberg, Wells Fargo Investment Institute, January 31, 2021. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. Please see end of report for index definitions.
We believe that equity volatility — as defined by the Chicago Board Options Exchange Volatility Index (VIX) — entered a new and higher “regime” in early 2020 primarily as a result of the coronavirus pandemic. From mid-2012 until that point, monthly VIX readings were generally well below their long-term average of 19.5, save for a few brief spikes. For hedge funds, volatility is like soup — they like it not too hot, not too cold, but just right. This “goldilocks” volatility environment that characterized 2020 and — so far — 2021 is one key reason why we’ve seen strong returns from strategies predicated on optionality, such as convertible bond arbitrage. Derivatives are highly sensitive to volatility, and strategies that can skillfully trade these securities have potential for strong returns.
Alongside higher equity volatility came a rather sudden and drastic increase in SPAC issuance. Here is where we see one of the more exciting opportunities for hedge funds this year, especially those that have a background in mergers and acquisitions (M&As) as well as derivatives trading. Because SPAC units include common shares and an equity warrant, and because the value of the warrant is generally expected to affected by volatility, we believe have an opportune environment for the nascent “SPAC arbitrage” strategy. We began to see funds generally increase their exposure to this sub-strategy in the middle of last year, and we anticipate the allocations to grow this year, especially given the feverish pace of SPAC initial public offerings (IPOs). While SPAC arbitrage can take several forms, one we have seen more frequently is hedge fund managers purchasing SPAC shares at a discount before a deal is announced. During this time, they seek to earn a small yield from the cash held in the trust while potentially gaining incremental return from the closing of the net asset value (NAV) discount. Generally we would expect SPACs shares to trade above NAV if the market views a deal as positive, at which point we would expect arbitrageurs to sell their positions. If the deal is not well-received by the markets, we anticipate the arbitrageur to redeem their SPAC shares upon shareholder vote for little to no loss. Upside optionality with the ability to mitigate downside risk — the quintessential arbitrage trade!
So far in 2021, 139 SPAC $44 billion in SPAC IPOs have been issued. This comes after a record year in 2020, when 231 or $81.5 billion in SPAC IPOs were issued. With little indication that the SPAC frenzy is slowing — and our expectations for higher than average volatility to continue — we believe the environment for SPAC arbitrage should be favorable this year.
by Ken Johnson, CFA Investment Strategy Analyst
Emerging market equities reaching new highs
In recent months, we’ve upgraded Emerging Market (EM) Equities from unfavorable to favorable. Since then the MSCI Emerging Markets Index (proxy for emerging market equities) hit a new all-time high, surpassing its 2007 peak. We believe several factors have contributed to the asset class’ success.
Foremost, Chinese markets, as measured by the MSCI China index extended its performance lead from last year, after it bypassed deep declines experienced by other developing countries. Exports have hit a recent snag; however, new export order data remains expansionary and we believe points to continued strength.
More broadly, a weaker dollar has supported higher EM equity prices — the two have historically moved in the opposite direction. The U.S. dollar has lost some of its appeal as international growth has become more competitive, U.S. rates have fallen, and U.S. fiscal debt has risen. Improvements in global coronavirus containment have helped to reignite investor sentiment toward risky assets. All the while, higher crude oil and material prices have enhanced investors’ palates toward commodity-producing equity firms found in Latin America, Emerging Europe, and Africa countries.
Unbalanced vaccine distributions across emerging countries we believe leave them more vulnerable to COVID-19 outbreak waves than the wider global economy. However, as we look ahead, we expect improving trade, strong global growth, and a persistently lower dollar should continue to benefit the asset class.
MSCI EM Index closes above its previous peak
Sources: Wells Fargo Investment Institute, Bloomberg, February 17, 2021. Past performance is no guarantee of future results. An index is unmanaged and not available for direct investment. See end of report for index definition.
by Brian Rehling, CFA Head of Global Fixed Income Strategy
A yield curve bear
In recent months, longer-term interest rates have been moving higher. Higher rates often lead to negative price performance on interest-rate-sensitive fixed-income securities — thus the bear nature of higher rates on performance. During this period of increases in long-term rates, short-term rates have remained anchored by the Federal Reserve’s (Fed) zero lower bound. This dynamic of higher long-term rates with short-term rates unchanged has led to a steepening of the interest rate curve, a “bear steepening”. The interest rate curve is a good reflection of the market’s expectation of future economic activity. A flat or negative interest rate curve generally indicates that challenging economic times may be ahead, while a steep interest rate curve tends to suggest that the market expects economic activity to improve.
We do not expect the Fed to change its stance on short-term rates for some time, thus short-term rates are unlikely to see much movement in yield. However, we do expect longer-term rates to continue to move gradually higher over time. This should lead to an extended bear steepening environment in fixed-income rate markets.
A bear steepening rate environment can be difficult to manage for many fixed-income investors. In the current environment, high-quality, short-term securities offer little in the way of yield making navigating this bear steepening cycle even more challenging. Maturities in the five- to seven-year range continue to offer a yield pick-up over short-term rates, are less rate sensitive than longer term maturities, and — we think — offer investors the most value on the curve today.
by Austin Pickle, CFA Investment Strategy Analyst
“When we are no longer able to change a situation, we are challenged to change ourselves.” — Viktor Frankl
Showcasing shifts in commodity sector guidance
We upgraded Agriculture commodities from neutral to favorable, and we downgraded Energy commodities from favorable to neutral in our February 12 Real Assets Quarterly Guidance report. Today we highlight those changes.
Oil prices have benefited from accelerating global economic growth and restrained supply — in the U.S. as well as Saudi Arabia and the rest of OPEC+. OPEC alone has over 7 million barrels per day of spare capacity or idled production that could be brought online in short order. Yet, oil’s recent rally could threaten that restraint. We suspect that oil producers — including OPEC+ members — are anxious to capitalize on higher prices and are chomping at the bit to increase production. We heard grumblings to this end when West Texas Intermediate (WTI) price was below $50 during the January OPEC+ meeting, where some members pushed to increase production quotas. What will happen at the upcoming March 4 meeting if WTI is above $60? The increased likelihood of additional oil supply at these price levels is a key rationale for our Energy commodities downgrade.
Agriculture commodities had been a perennial commodity laggard since 2016, yet we believe that may be changing. The group has outperformed in back-to-back quarters and seems to have put in a significant relative performance bottom. Demand has improved and inventories have drawn down from extended peak levels, driving recent outperformance. We suspect these trends will continue, and we have followed up on our September 2020 Agriculture upgrade to neutral with another upgrade to favorable.
Performance since WFII’s favorable commodity rating (March 12, 2020)
Sources: Bloomberg, Wells Fargo Investment Institute, February 17, 2021. The commodities listed are the components of the Bloomberg Commodity Total Return Index.
Download a PDF version of this reportColocation involves placing servers as close to exchanges as possible in order to mitigate trading latency.
Citi, SPAC Weekly Updated, February 18, 2021.
The Organization of the Petroleum Exporting Countries and others such as Russia.
Risk Considerations
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.
The use of derivatives, such as options, warrants and swaps, can expose the investor to additional risk. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks which may hurt a fund’s performance. Counterparty risk is the risk that the other party to the agreement will default at some time during the life of the contract. Investing in derivatives carries the risk of the underlying instrument as well as the derivative itself and may not be successful, resulting in losses to the portfolio, and the cost of such strategies may also reduce the portfolio’s returns.
Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.
Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.
Definitions
Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Bloomberg Commodity Total Return Index reflects the returns that are potentially available through an unleveraged investment in the futures contracts on 19 physical commodities comprising the Index plus the rate of interest that could be earned on cash collateral invested in specified Treasury Bills. The Index is a rolling index rebalancing annually.
Chicago Board Options Exchange Volatility Index (VIX) reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.
An index is unmanaged and not available for direct investment.
General Disclosures
Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability or best interest analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. The material contained herein has been prepared from sources and data we believe to be reliable but we make no guarantee to its accuracy or completeness.
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