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...

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Banks Warn Fed They May Have To Start Charging Depositors

 The Fed's Catch 22 just got catchier. While most attention in the recently released FOMC minutes fell on the return of the taper as a possibility even as soon as December (making the November payrolls report the most important ever, ever, until the next one at least), a less discussed issue was the Fed's comment that it would consider lowering the Interest on Excess Reserves to zero as a means to offset the implied tightening that would result from the reduction in the monthly flow once QE entered its terminal phase (for however briefly before the plunge in the S&P led to the Untaper). After all, the Fed's policy book goes, if IOER is raised to tighten conditions, easing it to zero, or negative, should offset "tightening financial conditions", right? Wrong. As the FT reports leading US banks have warned the Fed that should it lower IOER, they would be forced to start charging depositors.In other words, just like Europe is already toying with the idea of NIRP (and has been for over a year, if still mostly in the rheotrical and market rumor phase), so the Fed's IOER cut would also result in a negative rate on deposits which the FT tongue-in-cheekly summarizes "depositors already have to cope with near-zero interest rates, but paying just to leave money in the bank would be highly unusual and unwelcome for companies and households."If cutting IOER was as much of an easing move as the Fed believes, banks should be delighted - after all, according to the Fed's guidelines it would mean that the return on their investments (recall that all US banks slowly but surely became glorified, TBTF prop trading hedge funds since Glass Steagall was repealed, and why the Volcker Rule implementation is virtually guaranteed to never happen) would increase. And yet, they are not:Executives at two of the top five US banks said a cut in the 0.25 per cent rate of interest on the $2.4tn in reserves they hold at the Fed would lead them to pass on the cost to depositors.Banks say they may have to charge because taking in deposits is not free: they have to pay premiums of a few basis points to a US government insurance programme.“Right now you can at least break even from a revenue perspective,” said one executive, adding that a rate cut by the Fed “would turn it into negative revenue – banks would be disincentivised to take deposits and potentially charge for them”.Other bankers said that a move to negative rates would not only trim margins but could backfire for banks and the system as a whole, as it would incentivise treasury managers to find higher-yielding, riskier assets.“It’s not as if we are suddenly going to start lending to [small and medium-sized enterprises],” said one. “There really isn’t the level of demand, so the danger is that banks are pushed into riskier assets to find yield.”All of the above is BS: lending has never been a concern for the Fed because if it was, then one could scrap QE right now as an absolute faiure. Recall that as we showed recently, the total amount of loans and leases in commercial US banks has been unchanged since Lehman, with the only rise in deposits coming thanks to the fungible liquidity injected by the Fed.Furthermore, contrary to what the hypocrite banker said that "the danger is that banks are pushed into riskier assets to find yield”, banks are already in the riskiest assets: just look at what JPM was doing with its hundreds of billions in excess deposits, which originated as Fed reserves on its books - we explained the process of how the Fed's reserves are used to push the market higher most recently in "What Shadow Banking Can Tell Us About The Fed's "Exit-Path" Dead End."What the real danger is, is that once the Fed lowers IOER and there is a massive outflow of deposits, that banks which have used the excess deposits as initial margin and collateral on marginable securities to chase risk to record highs (as JPM's CIO explicitly and undisputedly did) that there would be an avalanche of selling once the negative rate deposit outflow tsunami hit.Needless to say, the only offset would be if the proceeds from the deposits outflows were used to invest in stocks instead of staying inert in some mattress or, worse (if only from the Fed's point of view) purchase inert assets like gold or Bitcoin.Which brings us back to the first sentence and the Fed's now massive Catch 22: on one hand, shoud the Fed taper, rates will surge and stocks will once again plunge, as they did, in early summer, just to teach the evil, non-appeasing Fed a lesson.On the other hand, should the Fed cut IOER as a standalone move or concurrently to offset the tapering pain, banks will crush depositors by cutting rates, depositors will pull their money from banks en masse, and banks will have no choice but to close on a record levered $2.2 trillion in margined risk position.Average: Your rating: None Average: 4.8 (6 votes)