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Hedge funds, ‘hybrid alternatives’, in the hot seat

Analysis

Uncertainty has returned to the market after a bumper 2020, fuelled by persistent inflation and a pandemic that never really went away. But in its latest alternatives outlook, JPMorgan warns that investors aren’t seeing the forest for the trees.

“Up close, the “trees” in the 2022 outlook are clear,” writes Anton Pil, global head of alternatives at JPMorgan Asset Management. “Consumers will keep spending. So, too, will governments, mostly with money they don’t have. Central banks will taper bond purchases, even if there are no buyers to replace them. Interest rates will rise. Transitory inflation will prove to be anything but. The equity market’s volatility will likely be surpassed only by Bitcoin’s. COVID-19 looks set to continue roiling our lives and markets. All this we know.”

“But take a step back and the “forest” emerges, filled with both dangers and wonders. In the forest, you’ll encounter perils to investment success – stretched valuations in traditional markets, limited correlation benefits between fixed income and equities, and persistently low bond yields – but also marvels, such as the megatrends of environmental, social and governance (ESG) considerations and technological adoption.”

Faced with an environment where it will be harder to generate stable income returns and alpha through public markets alone, investors must instead pursue a “hybrid” investing style – primarily, JPMorgan believes, through “hybrid alternatives”, which exhibit equity- and fixed income-like characteristics.

“Critically, they can provide public equity diversification, stable returns and the potential for alpha/growth,” the report says. “These hybrids are less well understood than traditional investments and generally less liquid. In the current environment, they are also relatively mispriced, which presents an attractive entry point for investors.”

For fixed income, hybrid alternatives include real estate and infrastructure debt, as well as various segments of private credit – “particularly attractive for investors that can accept some illiquidity in exchange for enhanced yields”, and which can also offer the downside protection for public market equity exposure that may now be less available from traditional fixed income securities. For equities, hybrid alternatives include non-core real assets and private equity, where digital transformation is creating new opportunities to generate incremental alpha.

Then there’s what JPMorgan thinks of as “pure hybrids” (core real assets and hedge funds) which exhibit characteristics of both equities and fixed-income. In an environment where volatility will be elevated, though not necessarily extreme, hedge funds are in the hot seat.

“Uncertainty may be the only certainty, but our hedge fund investors see significant opportunities for alpha generation as markets recalibrate for an ever more unpredictable future,” the report says. “Elevated levels of stock and factor dispersion, for example, are creating positive tailwinds for relative value and arbitrage strategies that focus on identifying price discrepancies among securities with similar characteristics.”

JPMorgan believes hedge funds also stand to benefit from a number of secular trends, including the drive towards more sustainable business – as theme “percolating through (JPMorgan’s) macro funds – as well as improved corporate governance standards in Japan, where progress will continue to be made as activist managers apply more pressure to a system that has long been known for complex cross shareholding structures.

“One of the newest themes that we’ve begun to implement concerns technology solutions around cybersecurity, which is likely to prove extremely resilient, even in an inflationary world, because it’s a compelling structural growth story based on the rapid expansion of cloud computing,” the report says. “Investment flows continue to increase dramatically to the sector as the risks of data breaches get higher and higher, creating opportunities for selective exposure to high growth companies.”




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