Financial markets faced a more challenging environment in 2018 than the year before, as resurgent concerns about global growth triggered volatility and damped returns.
With equities achieving new record highs at the start of the year, the margin for error was limited, as demonstrated on several occasions as sentiment swung between complacency and sudden anxiety. Global stocks ended 2018 almost 9% lower, making for a largely unsatisfying year for many equity‑linked alternative strategies.
Despite the market backdrop, some hedge fund strategies were able to generate solid returns in 2018. In Discretionary Macro, managers who positioned themselves for rising interest rates in the U.S. coupled with a rising Dollar were rewarded as these events played out as expected. Emerging markets also proved to be fertile territory, as managers were able to take advantage of an increasingly diverse range of tradeable securities to capitalise on market‑moving events.
The Alternative Investments Department has a mission to diversify and enhance risk‑adjusted returns in ADIA’s overall portfolio, primarily by investing across hedge fund strategies. Within this context, the Department not only fulfilled its mission but also outperformed its benchmarks.
The Department was able to capitalise on positive trends in large part through prudent manager selection, allowing it to end the year ahead of relevant benchmarks.
As has been the case since 2015, Relative Value strategies outperformed in 2018, as correlations between asset prices continued to unwind after years of quantitative easing. This trend has allowed managers to generate consistent outperformance by capitalising on differences in fair value between related financial instruments.
However, while Relative Value has been the most consistently successful strategy of recent years, history shows that it may be tested if volatility increases further and liquidity or financing decreases.
Not surprisingly, given the performance of equity markets during the year, equity‑related strategies including Equity Hedge and Event Driven ended the year slightly down.
It was a more challenging picture for Systematic, or trend‑following, strategies in 2018. These strategies struggled to capitalise on the sudden market swings that emerged during the year.
As with other strategies that seek to diversify portfolios against market downturns, Systematic hedge funds tend to perform best when markets trade on fundamentals, creating consistent price trends. However, disruptions caused by unexpected policy shifts, such as trade disputes, make it harder to capitalise on market trends, as was the case in 2018.
Meanwhile, the Alternative Investments Department had another active year, as it sought to further enhance its ability to capture new and emerging alternative investment opportunities. Key developments included finalising the build out of its Emerging Opportunities (EO) team, which was fully staffed by year‑end in preparation for its first investments in early 2019. While the EO mandate constitutes a small portion of the portfolio, it provides the Department with the flexibility to gain first‑hand experience in new areas of investing, with a view to increase exposure to those that show the most promise.
Looking ahead, there are indications that last year’s performance may signal what is likely to be a more volatile market environment going forward. As almost a decade of monetary easing gives way to gradual tightening, investors are likely to focus increasingly on geopolitical factors, slowing growth, and the fading effects of tax cuts on spending in the U.S. Recent data suggest that investors are already beginning to position themselves more defensively, with increased inflows to Systematic and Discretionary Macro strategies.
For the hedge fund industry as a whole, the Department has identified a number of emerging trends that are likely to further develop in the years to come. Among these, we expect that the boundaries between strategies will blur, as successful single‑strategy managers develop their offerings and business models. There are already examples of this, with systematic managers applying their models across different asset classes, including credit default swaps, interest rate swaps, and cash equities. This trend is being driven in part by an increased migration of investor capital toward established and well‑regarded managers, who may also look to inhabit areas that were once the sole responsibility of banks, such as providing liquidity.
However, as more money coalesces under fewer large funds, this will also encourage new funds to push the boundaries with alternative offerings. Technology will continue to play a large role, as managers across strategies invest heavily in new areas to seek a competitive edge. By investing in a diverse range of funds and strategies, of varying size, the Department is seeking to ensure it remains optimally positioned to capitalise on key trends in the industry.