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Risk sentiment turned negative in Q3 as hawkish Federal Reserve (Fed) rhetoric, concerns over fiscal sustainability, and a surge in oil prices culminated in a notable sell off in equities and rates.

While conventional 60/40 portfolios were challenged as correlations across asset classes turned positive, �۶���Ƶ Hedge Fund Solutions’ (“HFS”) broad based diversified and broad based neutral hedge fund strategies generally produced positive returns for the quarter. Within Trading, curve steepening positions benefited from the move higher in long-term rates, while natural gas trading in commodities was also additive to returns. In Equity Hedged, the risk-off tone bode well for managers’ short positions. These gains were supplemented by income derived from ABS and agency mortgage strategies, as well as cash/futures basis trading within fixed income relative value (FIRV). Overall, we are pleased with our outperformance (versus traditional risk assets) as it showcased the key role hedge funds can play in a well-diversified strategic asset allocation. That said, we recognize that a 5% risk-free rate is a formidable benchmark which we strive to beat without altering the consistency of our returns.

We believe the repricing in Q3 reflects market participants coming to terms with a higher-for-longer rate environment, aligning with our views. While COVID-induced supply shocks have mostly faded, the inflationary forces stemming from secular dynamics such as an aging population, the energy transition, and tectonic shifts in geopolitics, warrant higher rates for the foreseeable future. Further corroborating the case for higher real rates is economic resilience. Despite a general slowdown in some of the forward-looking growth indicators, the private sector is in much better shape than it has been in previous cycles. US consumers, particularly homeowners, continue to enjoy historically low mortgage debt payments, rising real income (albeit decelerating), and 15 years of accumulated wealth (via financial [and housing] asset inflation). Trends like these have helped sustain GDP growth, which in turn, may require restrictive monetary policy to prevent a rapid pick-up in inflation.

We expect a prolonged period of higher cost of capital will inevitably result in some form of recession. The recent rise in treasury yields and the escalating conflict in the Middle East may also increase the risk of recession and/or a left tail event (relative to last quarter).

As such, we maintain a defensive positioning across our allocations. FIRV and macro strategies remain core allocations as they are expected to benefit from a continuation of elevated rate volatility. Tactical Macro Trading managers may also offer positive convexity should there be a more pronounced deterioration in economic conditions and asset prices (as they have done so historically). In Equity Hedged, our allocations are primarily driven by bottom-up factors; in addition to market neutral/multi-PM strategies, we position ourselves with sector specialists trafficking in more inefficient, alpha-rich pockets of the market, as well as with managers who have demonstrated expertise on the short side. Within Credit/Income, and with cash yielding 5%, we place increasing emphasis on sourcing short duration, carry-oriented strategies that offer less correlation to broader markets. This is mostly complemented by allocations to more trading-oriented corporate long/short managers that can be nimble in turbulent markets.

Trading

We believe that the outlook for developed market (DM) macro strategies could improve with a more persistent trend of curve steepening in the US and other G3 markets. Managers could also benefit from short rates in Japan if inflationary pressures continue. Additionally, we expect DM-focused managers to perform well in a recessionary environment, be it via front-end longs or bull steepeners, as well as short positions in equities and credit. We maintain our allocations within emerging markets (EM), after having added to this segment in previous quarters. While EM managers were challenged amid the risk-off tape in Q3, the opportunity set still appears to be attractive, with potentially better entry points into some of the receiver trades and FX carry trades in countries that still hold a material real rates buffer. In commodities, we continue to reduce our target allocation, with our remaining exposure focused on gas/power strategies, complemented by strategic long investments in less correlated green materials.

Citi Economic Surprise G10 Index

Source: Bloomberg; Daily data; Jan 2, 2020-Oct 4, 2023. Discretionary trading strategies generally tend to underperform when the index is closer to zero, which indicates that economic data releases are generally in line with market expectations. Macro managers tend to perform better on macro data surprise, be to the upside or downside. US numbers continue to surprise to the upside, while negative news in Europe seems to have been more priced in and the backdrop is generally improving. There is less variation in the UK and Japan. Indices are for illustrative purposes only. Please see end notes for index descriptions. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

Relative Value

We continue to favor fixed income relative value (FIRV) strategies and plan to maintain our allocations. Q4 and Q1 tend to be beneficial for FIRV managers, with opportunities arising from potential year-end funding dislocations and the release of issuance schedules; thus, our 6-month forward-looking return expectations for the strategy remain strong.

Meanwhile, our outlook for capital structure/volatility arbitrage remains positive as the 2025-2026 maturity wall could lead to a surge in new issuance and corporate actions which should benefit the opportunity set.

German vs US Invoice Spreads

Source: Bloomberg; Daily data; Oct 6, 2022-Oct 17, 2023. Data illustrates German and US 10y “invoice spreads” over the last year. Short swap spreads have been additive to manager performance this year across both macro and FIRV strategies. The underperformance of cash bonds (sometimes expressed via futures, as shown here) against swaps is expected to continue as central banks continue the QT process while governments need to issue more debt to fund higher fiscal needs. Indices are for illustrative purposes only. Please see end notes for index descriptions. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

Equity Hedged

We strive to maintain a low-beta construct. Our allocations mostly consist of sector specialists trafficking in more inefficient, alpha-rich pockets of the market (e.g., technology/AI), as well as managers with more diversified exposure that have demonstrated strength on the short side. This is also complemented by allocations to market neutral/multi-PM strategies.

We maintain minimal exposure to China given the weak economic rebound thus far and underwhelming government stimulus. While we have seen signs of stabilization in markets, liquidity constraints may present additional challenges for managers with a focus on short selling. After 30 years of depressed inflation, Japan may be transitioning to the next phase of the economic cycle, where rising inflation and higher interest rates could create a healthy amount of dispersion in equity markets that is conducive for fundamental investing.

Short Alpha

Source: Bloomberg; Monthly data; Jan 1, 2023-Sep 29, 2023. Data illustrates the short alpha (calculated as SPX index minus the average of GSCBMSAL index, MSSHRTUS index, MSXXSHRT index, GSTHVISP index). Please see end notes for index descriptions. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

Credit/Income

As rates reach peak levels, we continue to seek short duration income opportunities with lower correlation to corporate credit spreads, expressed through a mix of thematic funds and co-investments with attractive carry. One example of this is an opportunity in US residential real estate debt that, despite strong fundamentals, was attractively priced due to funding pressures faced by regional banks. Elsewhere in credit, our exposure to agency MBS remains full as it provides a source of carry without -credit risk given the government guarantee. The strategy also benefits from multi-decade low prepayment speeds. We plan to maintain current allocations to corporate long/short approaches. The opportunity is expected to remain as corporate distress, default activity and overall dispersion picks up, providing opportunities across fundamental long/short, event-driven, stressed and special situations. Our allocations to corporate long-biased and distressed remain underweight. Distress in the corporate sector has increased, spreads remain tight and better entry points will likely emerge later in the credit cycle.

Investment grade and high yield cash spreads

Source: Bank of America Merrill Lynch; Daily Data; Jun 30, 2018-Sep 30, 2023. Indices are for illustrative purposes only. Please see end notes for index descriptions. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.