Hedge funds Hedge funds A new paradigm for equity long-short alpha? We appear to be entering a new paradigm in financial markets: the implications for equity long-short are potentially significant. Here, Bernie Ahkong, Head of UBS O’Connor in Europe and Co-CIO of O’Connor Global Multi-Strategy Alpha, gives his outlook for this strategy. Bernard Ahkong Head of UBS O’Connor in Europe Co-CIO of O’Connor Global Multi-Strategy Alpha he last two years have been very difficult for global Historically, this has been positive for relative value long-short Chart 2: Rising bond market volatility high growth companies regardless of valuation, and arguably equity long-short alpha strategies, compared to the equity investing. Chart 2 shows the MOVE Index – which looks 300 diluted the skillset of focusing on relative valuation and capital Tprevious decade. Dramatic shifts in the macroeconomic at near-term implied volatility across different US Treasury structure differences. environment have challenged long-held microeconomic maturities – reached levels during October last seen during the 250 assumptions and global equity long-short strategies global financial crisis of 2007-2008. We believe that this potential new paradigm favors teams have struggled. l200 with: experience through past cycles; a focus on bottom-up 150 fundamental analysis combined with a strong relative value Inflation has moved up to levels not seen since the 1980s Chart 1: Global alpha generated by hedge funds framework; and collaboration between teams across asset and central banks have aggressively tightened monetary Index Leve100 classes. There are also areas with structural alpha tailwinds policy. As a result, higher valued companies have been % relating to regulatory, policy, geopolitical and thematic disproportionately impacted as they are typically the higher 8 50 change, which relate less to variables like interest rates and growth or higher quality companies that equity investors are 6 inflation. These are areas like China, private credit, event- positively biased towards. A sustained and persistent increase 4 0 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 driven situations, energy transition and trade finance. in interest rate volatility has also led to higher factor volatility, 2 ICE BofAML MOVE Index influencing equity prices more frequently and heavily, which is 0 Source: ICE BofAML MOVE Index, to 10 November 2022 In China we see four supportive factors operating together – not something fundamental equity long-short managers are -2 high retail participation, low institutional investor interest, low accustomed to. -4 Many inflation data points have surprised to the upside this research analyst coverage relative to other major markets, and -6 year, leading the US Federal Reserve to hike interest rates improving liquidity for institutional investors. We believe this Chart 1 shows data from Morgan Stanley Prime Brokerage, -8 aggressively and rate volatility to spike. However, regardless of will create a conducive environment for long-short investing illustrating the average global alpha generated by their -10 your view on inflation and central bank policy from here, it is regardless of the market environment. hedge fund client base during the 2010-2020 period difficult to see rate volatility staying this elevated in 2023. compared to 2021 and 2022 YTD. Avg 2010-2020 2021 2022 YTD Equity long-short alpha has indeed been more challenging Something has changed structurally, though. Years of accommodative of late, and will require capabilities that not all investors are Cyclically, we could see some mean reversion from here given Source: Morgan Stanley Prime Brokerage, data as of 30 September 2022 central bank policy and supportive demographics from emerging equipped with. Yet there are cyclical and structural reasons the scope for rate volatility to move lower from an elevated markets have led to a structurally low interest rate and inflation for investors to be more constructive on the opportunity set starting point. environment. This helped support a backdrop of backing as we move into 2023 and beyond. 14 15