Hedge Fund Managers Fear Credit Bubble Explosion

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While the shift from active to passive funds has widely been seen as bad for active fund managers in general, the cloud does have a silver lining. Managers of one well-invested fund of funds have pointed out some interesting angles of the active/ passive debate.

More opportunities for skilled value managers

In their first-quarter letter for their Weatherlow fund of funds which was reviewed by ValueWalk, the Evanston Capital team said they attended a number of conferences for the hedge fund industry during the quarter. Among the topics covered at the conferences was the active/ passive investing debate, and Evanston’s discussion took two angles.

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Q1 hedge fund letters, conference, scoops etc

The first was a silver lining in the overall shift from the preference for active to passive investing. The Evanston team said the general view of this shift has moved from a generally negative one to a view "that the more money that goes into passive indexing, the greater the inefficiencies that should exist for skilled active managers to exploit given reduced competition." In other words, there should be even more opportunities for skilled active managers to take advantage of because the field is shrinking.

There is one negative aspect to this silver lining, however. The timeframe for these inefficiencies to reverse could end up being longer because there aren't as many active managers to step in and "take advantage of mispriced securities."

"This appears especially true in 'value' sectors such as consumers, industrials and real estate, where shrinkage in the active manager roster has been particularly acute, while being less prevalent in higher-growth, faster-changing sectors such as technology and healthcare," the Evanston team explained.

Fundraising remains easy for the "haves"

They also noted that "well-pedigreed" managers, which they describe as the "haves," are still able to raise assets. They see the hedge fund industry as increasingly split between the "have" and the "have nots." Investors continue to seek out new funds launched by "portfolio managers with verifiable records of success who are spinning out of well-regarded shops."

Risk-averse institutional investors are attracted to these managers because they are considered to carry a "lower risk of failure." These investors usually don't invest in startup funds, but they seem to make exceptions for managers from reputable shops. Due to this trend, startups from managers who have spun out of well-known management shops tend to raise billions of dollars in capital for day one, often with premium-level fees.

Trouble for the "have nots"

On the other hand, managers who are less well-known tend to capture $25 million to $50 million at most because fundraising has become much more difficult. Even talented investors in this category are having difficulties because most large investors "are not willing to take on the risk of an unproven strategy."

Evanston adds that a decade ago, these managers may have been able to raise "several hundred million of capital at launch given the money pouring into the hedge fund industry." However, this has changed dramatically. Because of this change, they see opportunities here for their Weatherlow fund of funds.

"We continue to believe this latter group is where we can add real value, using our experience and expertise to identify and underwrite talent early in the hedge fund life cycle," they explained.

Sentiment is back to positive

They also covered a number of other topics in their Q1 letter, like investor sentiment. Even though the fourth quarter was fraught with turmoil in the markets, investors seemed less negative than some may have expected them to be. This is likely due to the strong rebound in the first quarter, which was already underway by the time of the conferences. The Evanston team added that a lot of the bullishness stems from the belief that the Fed won't raise interest rates again any time soon unless inflation surprises to the upside.

Overall views on China are also generally bullish. Although sentiment on the country shifted to the negative last year as growth worries and the trade war with the U.S. weighed. However, Chinese policymakers have been making changes, which have quelled many of those concerns. As a result, investors generally expect that the "money on the sidelines will rush to reinvest, leading to a strong recovery in asset prices."

Recession coming in 2020

The Evanston team also discussed the credit bubble, explaining that credit managers who attended the conferences tend to be cautiously bullish in the short term and bearish in the long term. The Fed's reprieve on interest rates is the reason for the short-term view. However, over the medium and long term, credit managers generally believe the markets are "in the last leg of a historic economic expansion." They also expect the U.S. to enter a recession at some point next year.

Another big problem for credit managers is the credit bubble.

"…there similar isn't enough capital to support the colossal amount of corporate debt outstanding, and the credit bubble is unlikely to survive an economic downturn," they wrote. "The high yield market is at peak size and half of investment grade bonds are rated BBB, which is one rung above junk territory. If there is another sustained spread widening similar to or in excess of the fourth quarter move, then longer duration and lower quality bonds will have a hard time living up to their ratings."

They add that price action would become quite painful in the event of further downgrades, but distressed debt funds would likely benefit from the setup coming out of that.

This article first appeared on ValueWalk Premium

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