Demystifying hedge fund strategies: Finding non-correlated returns

A new market update from Chief Market Strategist Troy Gayeski

Troy A. Gayeski
April 28, 2022

This strategy note will attempt to demystify trade and theme expressions in hedge fund strategies. We frequently hear from clients seeking investments that offer the potential for low volatility, low beta, no duration return streams with daily liquidity, but find that applicable hedge fund strategies can be complex.

In general, every investment strategy should be making a series of carefully constructed trades or investment themes with attractive risk/reward profiles. The problem for most investment strategies now, however, is that they are fighting the Fed with some level of beta and/or duration, and that is a losing strategy in 2022. In low beta and duration neutral multi-strategy funds, managers deploy a series of carefully constructed trades or investment themes. These themes are not fighting the Fed like many investment strategies. They might not be “High Fiving the Fed” like floating rate debt strategies in every expression, but they are generating returns by different means that have the potential to take advantage of the volatility created by the Fed – and have better liquidity profiles.

Some examples of our favorite multi-strategy themes right now are:

1. Short the Mortgage Basis (Long Treasuries/Short Agency Mortgages—Negative Carry/Long Volatility): This method makes money when most other trades lose, and vice versa, but if nothing happens you lose money:

a. The Fed was the largest buyer of Agency Mortgage-Backed Securities (MBS) the last two years (and over the past 13 years), driving the spread or yield differential between Agency MBS and Treasury Bonds to unsustainably low levels.

b. Surprise: The Fed has stopped buying mortgages and are likely going to allow some of their holdings to run off. Who knows, maybe they’ll even sell some back to investors given the political pressure on them to “do something about inflation.”

c. Shockingly (sarcasm intended), as the Fed started to step back from purchases, the price and spread between mortgages and treasuries have begun to widen back toward historical levels, leading to profitable trades when most other investments lost money.

2. Dispersion (Flat Carry/Long Volatility): This approach does not lose money if nothing happens but typically makes money when markets get more volatile:

a. Dispersion refers to the idea that equity performance will exhibit more misses and beats than usual. Coming into Q1 earnings there was a higher probability that there would be a much wider range of individual equity outcomes (both better and worse) than expectations.

b. This was and is a direct function of the new world order of nominal GDP growth being dominated by inflation instead of real GDP growth.

c. This theme is driven by high inflation, rising costs, and an inability to pass costs through in some cases, but in other cases creates even better ability than forecast to cope with this environment.

d. Surprise, surprise, Dispersion has already performed better than expected with Netflix getting crushed, and more earnings volatility may come to pass.

e. Dispersion is generally independent of market or economic direction.

3. Long Dividend Futures (No positive carry and counting on the economy not to collapse): More efficient way to play economic strength than being long equities:

a. In terms of confidence in outcomes—the base case for this year and next is that we experience a great mean reversion between the real economy and financial markets. After years of galactically better outcomes for financial markets than the real economy, this year and next should be the opposite (mainly driven by Fed policy in both directions).

b. Long Dividend Futures allow you to take a view that we will have attractive nominal (including inflation) economic growth, which will lead to revenue, earnings, and dividend growth without fighting the inevitable multiple compression in equities caused by Fed tightening.

c. Also, dividends tend to exhibit the following:

i. They grow more in an inflationary environment than a slow nominal (real growth + inflation) growth environment and dividends have a long way to go to catch up to the 10-year Treasury yield and historical averages.
ii. They tend to be far stickier in a recession than earnings.

d. Given recent heightened recession fears, one could put on dividend future exposure with a roughly 4:1 risk/reward (four times the upside if dividends grow as expected vs. the downside in a mild recession scenario).

e. However, in bad enough economic and market outcomes, dividend futures will lose money when equities lose money.

4. Short Upside Equity Volatility (Positive Carry/Short Volatility):

a. One would never put this trade on if we were in an environment like 2020 and 2021 when there was so much market melt-up risk (green-light go environment)

b. The trade is expressed by selling out of the money calls on the S&P and delta hedging the underlying market moves (limiting gains but also limiting losses)

c. As long as the market doesn’t gap higher and stay there (anything is possible, but that scenario is highly unlikely), one should be able to collect positive carry throughout the year

d. Importantly, the theme can generate returns when equities struggle.

5. Long Dated Interest Rate Volatility (Positive Carry/Long Volatility):

a. Since the Fed has dominated mortgage purchases for years, long-dated interest rate volatility became cheaper than short-dated interest rate volatility (meaning market participants will pay more for short-dated interest rate volatility than long-dated).

b. This is because the Fed supplanted the buy side need for hedging long-dated interest rate movements due to their dominance of the Agency MBS market.

c. So, one could go long-dated interest volatility and collect positive carry rolling up the interest rate volatility curve, meaning you make money if nothing happens and make more if interest rate volatility increases. Conversely, if interest rate volatility collapses and/or longer-dated volatility gets even cheaper than shorter-dated volatility, you can lose money.

d. In general, it is very rare to have a positive carry expression that is actually long volatility.

e. This trade has been a big winner so far, as interest rate volatility has increased dramatically.

f. One would be wise to start reducing this trade expression to monetize gains as the potential for further interest rate volatility increases has declined.

Hopefully, this note has demystified some of the ways hedge fund strategies can generate returns. If you have any questions, please let us know as we are happy to dive into more (or less) detail.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

All investing is subject to risk, including the possible loss of the money you invest.

Troy A. Gayeski, CFA

Chief Market Strategist

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