HSBC Alternative Investments outlines outlook for various hedge fund strategies

Date: Wednesday, April 2, 2008
Author: HSBC

Convertible arbitrage
Most managers expect valuations to continue to be affected in the short term by distress in the credit markets. In these markets, extreme volatility can negatively affect valuations due to the limited liquidity and flight to quality by investors.

Although increased levels of volatility and new issuance bode well for convertible bond managers, those which are heavily invested have faced a tough environment as widening credit spreads and an overall deleveraging has stressed an already illiquid market.

As issuers have been forced to re-price new deals lower, in order to attract investors, secondary market prices have been forced lower, hurting managers on a mark to market level. Those with free cash and low levels of current investment will benefit as they are able to buy into cheap new issue converts.

A premium has also been added for liquidity, reflected in the outperformance of larger cap over smaller cap issues. Several managers have used this opportunity to reduce the overall duration of their book and increase their credit quality.

Due to heightened levels of volatility and the expected elevated issuance levels, with a robust pipeline over the next few months, we maintain our position of neutral/positive.

Fixed income arbitrage
Some managers have highlighted the decreased risk reward profile of directional shorts in credit, which have been profitable for the past couple of months. The implied probability of default recently seen in spreads is so drastic that it predicts a default of a scale that hasn’t been seen in decades, and many managers do not subscribe to this view.

However, they are also realistic that at some wider level of spreads, a general clearing of the backlog would occur as forced sellers and deep bargain hunters emerge. The increased levels of volatility and the increasingly attractive prices of depressed assets bode well for the strategy, leading us to maintain our outlook of neutral/positive.

Macro
Long positions in a range of commodities have continued to prove profitable for managers as trends continue upward. Despite the expected declines in demand from global developed economies, several commodities have benefited as a hedge against the falling USD, real estate and general equities, in addition to continued demand from emerging markets. Long precious metals, crude and the soy, wheat, corn complex were particularly strong. Due to the strong environment for fixed income investing and commodities, both of which help this strategy, we remain neutral/positive.

Event driven/multi-strategy
While merger opportunities have slowed, some sectors which are cash rich have not been as impacted and are expected to continue activity in the space, albeit at a slower pace. Equity market volatility is expected to remain at elevated levels, therefore we maintain our view of neutral/positive.

Statistical arbitrage
Equity market volatility is a key driver for this strategy. Due to the improved outlook, decreased competition in models and more robust trading, we maintain our outlook for the strategy of neutral/positive.

High yield/distressed
Default rates have slowly picked up, with most managers profiting modestly from select bankruptcies and short exposures. Credit markets remain under high stress levels, largely felt as cash markets continued to weaken, with poor bid levels from both bank proprietary desks and investors. Overall, the outlook for the distressed strategy remains neutral given the potential opportunities for the next 12-18 months. We remain negative on the high yield space due to the continued stress in the markets.

Equity long/short
Equity markets are proving increasingly challenging on a global basis with many retail investors hesitant to invest. Despite opportunities for stock pickers on both the long and short side, due to the continued uncertainty on markets, we maintain a neutral outlook on this strategy.

Equity market neutral
Market conditions continue to prove challenging for quantitative managers. Current stress in the markets may not be settled for a few months and we maintain our view of neutral.

Merger arbitrage
Despite the recent uptick in merger activity, due to the continued caution in the markets and the constraints on liquidity, we maintain a neutral outlook for this strategy.