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Publication Title | Hedge Fund Strategies Well Positioned for the Uncertainty of 2021

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“Given the lingering uncertainty surrounding the COVID-19 health crisis, the development of a vaccine, geopolitical events and governments’ policy response, we favor nimble, shorter-term strategies. It is prudent in our minds to remain somewhat conservative, but to seek opportunities within alternative investments with low correlation to broader risk assets.”
Discretionary macro managers are well-positioned, in our view, because macroeconomic events are likely to remain a leading market driver. Developments surrounding the health crisis, geopolitical negotiations and fiscal policy spending decisions around COVID-19 stimulus and inflation policy will likely continue to create market fluctuations and opportunities.
Long/short equity strategies may benefit from their ability to capitalize on both improving and weakening trends driven by the dispersion and volatility of pandemic-related disruptions and events. We also believe long/short credit managers could take advantage of the potential for an increase in company bankruptcies and bond defaults. We saw this during the March 2020 selloff, and while unprecedented stimulus efforts from global central banks have kept interest rates low and helped maintain liquidity, we are concerned that their effectiveness may wane in 2021.
One of the core themes behind this thinking is reflation. The US Federal Reserve’s shift toward flexible average inflation targeting represents the central bank’s latest effort to drive stubbornly
low inflation higher. That commitment, echoed by other central banks, may work in conjunction with potential increases in
fiscal spending for infrastructure, vaccine news and renewed economic growth to lift expectations for future inflation, prompting a steepening yield curve and a weakening US dollar.
Besides reflation, we are monitoring regulatory and tax policy shifts that could cap the rally in technology and health care stocks. We are also looking toward hedged strategies with a focus on recovery in Asia and emerging markets.
Looking Ahead, Post-Election
While the US elections are largely in the rearview mirror, it is still early to clearly envision the policy impact of the new administration, in terms of potentially higher taxes, shifting health care benefits, or regulating fossil fuel producers and technology giants. That said, President-elect Joe Biden’s views on traditional energy, information technology and health care costs indicate that these sectors may lag the broader market going forward. Conversely, industries within clean energy, industrials and
Brooks Ritchey
Senior Managing Director Co-Head of Investment
Research & Management K2 Advisors
Robert Christian
Senior Managing Director Co-Head of Investment
Research & Management K2 Advisors
December 2020
Outlook for Hedge Fund Strategy Investing
Hedge Fund Strategies Well-Positioned for the Uncertainty of 2021
Wide fundamental variances in valuations and growth prospects for various asset classes, geographies and sectors, often accelerated by the pandemic’s impact, defined the opportunity set for hedge fund-based strategies in 2020. Looking ahead to
2021, that divergence could well narrow, driven by catalysts such as reflation efforts, a weakening US dollar and the possibility of widespread changes in regulatory policies.
We see increasing signs of a potentially sustainable rotation in
the coming months, in which managers buy or add to sectors and markets that have lagged in recent years (and through the pandemic), while taking profits or applying hedges where they believe the good news has been priced into valuations. Staying on top of those rotations will likely be the key to strong performance potential. Nimble managers may look to a recovery for energy
and raw materials, such as base metals that could benefit from Chinese growth. Others may de-risk in the United States and
add to emerging markets. The ultimate driver could be one or more vaccines—which could be a game-changer, even if they are not adopted or available right away—or some other clear sign
that global growth is recovering.
Finding Opportunities amid Uncertainty
Over the next 12 months, we believe three hedged sub-strategies are likely to perform well and improve their risk/reward ratio.
Not FDIC Insured May Lose Value No Bank Guarantee

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SHORT-STOCKS: Shorting a stock means opening a position by borrowing shares that you don't own and then selling them to another investor. Shorting, or selling short, is a bearish stock position in other words, you might short a stock if you feel strongly that its share price was going to decline. Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price. It is an advanced strategy that should only be undertaken by experienced traders and investors. Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.

Short Selling Risk and Hedge Fund Performance: Hedge funds, on average, outperform other actively managed funds. However, hedge fund managers often use trading strategies that are not used by other managed portfolios, and thus they bear unique risks. In particular, many hedge funds use short selling. I construct an option- based measure of short selling risk as the return spread between the decile of stocks with low option-implied short selling fees and the decile of those with high fees. I find that hedge funds that are significantly exposed to short selling risk outperform low-exposure funds by 0.45% per month on a risk-adjusted basis. However, there is no such relation for mutual funds that invest primarily on the long side. The results highlight that a significant proportion of abnormal performance of hedge funds is compensation for the risk they take on their short positions.

Short selling meets hedge fund 13F: An anatomy of informed demand: The existing literature treats the short side (i.e., short selling) and the long side of hedge fund trading (i.e., fund holdings) independently. The two sides, however, complement each other: opposite changes in the two are likely to be driven by information, whereas si- multaneous increases (decreases) of the two may be motivated by hedging (unwinding) considerations. We use this intuition to identify informed demand and document that it exhibits highly significant predictive power over returns (approximately 10% per year). We also find that informed demand forecasts future firm fundamentals, suggesting that hedge funds play an important role in information discovery.

Active Short Selling by Hedge Funds: Short selling campaigns by hedge funds have become increasingly common in the last decade. Using a hand-collected sample of 252 campaigns, we document abnormal returns for targets of approximately - 7 percent around the announcement date. Firm stakeholders, including the media, plaintiffs’ attorneys, and other short sellers, play an important role in campaigns. Changes in aggregate short interest do not drive the effects on firm value and stakeholder behavior. Campaigns are primarily undertaken by activist hedge funds. Evidence suggests disclosure costs and information are important channels through which activism technology affects short selling.

An Introduction to Short Selling: Like so many other aspects of our daily lives, markets function best when they represent the broadest possible set of views. Short selling allows investors to say when they believe an asset is overvalued. This contributes to price discovery. The more efficient a market is at determining prices, the better it will function for investors. One way to think about this important process is to compare it to buying a house. You research the neighborhood and check prices of comparable houses before making an offer and the value you put on the house is sometimes lower than the price on the listing. This is why appraisals are required by your bank: they do not want you to pay more than it is worth.

Hedge Fund Holdings and Stock Market Efficiency: We study the relation between hedge fund equity holdings and measures of informational efficiency of stock prices derived from intraday transactions as well as daily data. Our findings support the role of hedge funds as arbitrageurs who reduce mispricing in the market. Hedge funds invest in stocks that are relatively inefficiently priced, and the price efficiency of these stocks improves after hedge funds increase their holdings. Hedge fund ownership contributes more to efficient pricing than ownership by other types of institu- tional investors. However, stocks held by hedge funds experienced large declines in price efficiency during several liquidity crises.

Short interest, returns, and fundamentals: We show that short interest predicts stock returns because short sellers are able to anticipate bad news, negative earnings surprises, and downward revisions in analyst earnings forecasts. They appear to have information about these events several months before they become public. Most importantly, the cross-sectional relation between short interest and future stock returns vanishes when controlling for short sellers’ information about future fundamental news. Thus, short sellers contribute, in a significant manner, to price discovery about firm fundamentals, but the source of their information remains an open question.

SHORT INTEREST AND STOCK RETURNS: Using a longer time period and both NYSE Amex and Nasdaq stocks, this paper examines short interest and stock returns in more detail than any previous study and finds that many documented patterns are not robust. While equally weighted high short interest portfolios generally underperform, value weighted portfolios do not. In addition, there is a negative correlation between market returns and short interest over our whole period. Finally, inferences from short time periods, such as 1988 1994 when the underperformance of high short interest stocks was exceptional or 1995 2002, when high short interest Nasdaq stocks did not underperform, are misleading.

Aggregate Short Interest and Market Valuations: The spectacular rise and fall of stock prices during the recent dot com bubble period has been accompanied by a surge of interest in the topic of short-selling.

Arbitrage Trading: The Long and the Short of It: We examine net arbitrage trading (NAT) measured by the difference between quarterly abnormal hedge fund holdings and abnormal short interest. NAT strongly predicts stock returns in the cross section. Across ten well known stock anomalies, abnormal returns are realized only among stocks experiencing large NAT. Exploiting Regulation SHO, which facilitated short selling for a random group of stocks, we present causal evidence that NAT has stronger return predictability among stocks facing greater limits to arbitrage. We also find large returns for anomalies that arbitrageurs chose to exploit despite capital constraints during the 2007 09 financial crisis. We confirm our findings using daily data. (JEL G11, G23)

Dedicated Short Bias Hedge Funds Just a one trick pony: During the recent period of significant market unrest in 2007 and 2008 dedicated short bias (DSB) hedge funds exhibited extremely strong results while many other hedge fund strategies suffered badly. This study, prompted by this recent episode, investigates the DSB hedge funds performance over an extended sample period, from January 1994 to December 2008. Performance evaluation is carried out both initially at the individual fund level and then on an equally weighted dedicated short bias hedge fund portfolio using three different factor model specifications and both linear and nonlinear estimation techniques. We conclude that DSB hedge funds are indeed more than a one trick pony. They are a significant source of diversification for investors and produce statistically significant levels of alpha. Our findings are robust to the specification of traditional and alternative risk factors, nonlinearity and the omission of the flattering credit crisis period.

LINKS TO NATIONAL WEBSITES WHERE NET SHORT POSITIONS IN SHARES ARE DISCLOSED: According to Article 9 of Regulation (EU) No 236/2012 on short selling and certain aspects of credit default swaps, net short position in shares should be publicly disclosed on a central website operated or supervised by the relevant competent authority. The address of that website should be communicated to ESMA, which should post on its own website. On the basis of the information received by ESMA, the following table lists the links to these central websites operated or supervised by relevant competent authorities. Where available, it also includes both the links to the national language and English versions of the relevant sections of the central website.

Instructions for Form 1099-B IRS: Proceeds From Broker and Barter Exchange Transactions. For whom the broker has sold (including short sales) stocks, commodities, regulated futures contracts, foreign currency contracts (pursuant to a forward contract or regulated futures contract), forward contracts, debt instruments, options, securities futures contracts, etc., for cash.

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