June 2016 could go down as one of the most significant months for hedge fund performance during the quantitative easing era. Of course the August market sell-off – a flash crash that was predicted for the first time in known history – was significant. Then the “V” shaped price sell-off and rebound in the first quarter 2016 was interesting as a benchmark. But compare it all with the “V” shaped Brexit drawdown-recovery pattern, and one may realize why June 2016 and the “Brexit V” crash and recovery might be most interesting. To benchmark the situation, consider the Morgan Stanley June 8, 2016 Hedge Fund Recap.

Also see a curated list of top hedge fund letters

MS 7 13 HF performance

Morgan Stanley identifies long end of relative value ratio management as causation of pain

Based on Morgan Stanley’s hedge fund performance benchmark, returns “languished” during the Brexit month. Claiming that performance suffered “across all HF (hedge fund) strategies,” the report, like many on Wall Street, ignored managed futures. Most systematic CTA strategies again exhibited the “hero” type performance in the face of weak-kneed Brexit panic. It’s not perfect in crisis, but generally the mathematically consistent strategy has a pretty good track record during market crashes and causation can be logically explained.

Morgan Stanley, for its part, again spotlighted long / short “alpha” as being negative for the fifth month in a row. This fascinating question has been tickling hedge fund allocators over the past 365 days and the three subsequent “V” shaped market crashes. Many traditional equity long / short strategies suffered during both this and the entire quantitative easing period. Morgan Stanley, for its part, noted that this by looking at only the Brexit performance. What was underperformance causation?

“US Style Factors negatively impacted long returns as Equity L/S funds had negative exposure to factors that performed best in June,” the report said. Equity long / short hedge funds in the US were off an average of -1.72% in June, while Asian long / short strategies were interestingly only down -0.52%. The big loser was the European long / short strategies, with an average -2.69% loss.

What is most meaningful to hedge fund allocators is why this occurred and will it happen again? The answer to that question is the difference between success and failure.

MS 7 13 HF performance EU longs

Analyzing various probability paths as to why long / short once again faltered

For Morgan Stanley to note the long end of the portfolio didn’t hold up is an interesting point. Looking at the disparity in performance between the globally-driven FTSE 100 – sales outside the UK are a significant factor – and the more muted FTSE 250, which includes smaller and more inwardly focused firms. Playing the wrong side of that relative value disparity would result in the long side of the relative value price relationship ending up generating negative alpha. Is an emerging “natavist” vs “globalist” relative value play approaching?

Morgan Stanley goes deeper on the topic without addressing the FTSE or global focus per say:

European longs had been recovering from late Mar to early Jun, but fell in the weeks leading up to Brexit and then even more sharply in the post-Brexit period. Due to the declines post-Brexit, European longs have recently underperformed even more than they had at the start of this year (Figure 3). Some factors that have contributed to the recent underperformance: Underweights in Staples, Health Care, Energy, & Utilities — all of which outperformed recently (including post-Brexit) Overweight in Financials, particularly Banks — Banks are down about 20% since the end of May Factor skews, including overweights to small caps and growth — both factors underperformed pre- and post-Brexit.

MS 7 13 HF performance short side

Ratio management could be one source of causation for long / short under-performance along with volatility triggers in portfolio scaling

What the report didn’t mention was the fund’s ratio management. “Traditional” long / short strategies were known to utilize ratio management that heavily favored the long side. Generally noncorrelated hedge funds, such as Balyasny Asset Management (BAM), are known to map logical risk probability paths and hedge accordingly. During the August 2015 crash, for instance, BAM portfolio managers were eying a potential Fed rate hike. Even expectations of a cut could result in a logical volatility point, an issue lightly addressed in the mainstream at the time. BAM adjusted their ratio management accordingly, sources close to the situation previously told ValueWalk. During the crisis they did not use volatility triggers to manage portfolio scaling. They survived the August crash and recover without loss and ended 2015 higher amid one of the worst stock markets in the quantitative easing era.

It is, of course, impossible to predict all volatility events. BAM appears to work on the assumption of likely volatility as a signal for their investment team to focus on preservation of capital to a larger degree.

While a negative long end of the book and ratio management might be causation for long short struggles, there could also be issues with risk management systems.

While hard data is not available on how the sub-strategies performed, some long / short strategies are known to employ risk parity, volatility targeting and other portfolio scaling methodologies that do not find an ideal market environment during a “V shaped” sell-off and recovery price pattern. This is primarily due to their position scaling during crisis and the associated volatility or standard deviation price movement systematic trigger associated with the general strategy.

These are the critical components that typically do not get discussed in public but are documented in general to have been causation for losses and have been questioned by top derivatives analysts.

What does the market environment look like going forward? Some discretionary and systematic analysis might point to additional “V” shaped price patterns until the election. If a serious market sell-off were to occur due to systemic issues — the bank derivatives that underlie the economic system, for instance — then the probability for a quick “V” shaped recovery would be dramatically reduced and the situation becomes much more unpredictable.