Strategy Outlook

UBS Hedge Fund Solutions’ Broad Based Diversified strategies generated positive returns in Q2 as risk assets generally continued to climb higher. From a strategy perspective, Equity Hedged, Credit / Income, and Relative Value strategies produced gains, while Trading was the only strategy to incur losses. Profits during the quarter were predominately led by Equity Hedged, with strong alpha generated in the technology and healthcare sectors. Credit / Income strategies also contributed to overall returns, driven by income from reinsurance and other less correlated, carry-oriented assets. Within Trading, Q2 was challenging for most commodities managers as price action was quite volatile within energy. Short positions in natural gas were negatively impacted by upward price pressure from unusually warm weather and production delays. Meanwhile, performance from discretionary macro managers was mixed as a slower pace of disinflation revived concerns over higher-for-longer rates. This created losses for long-biased positioning in emerging markets but benefited developed markets-focused managers with a hawkish bias.

We began the year expecting some degree of recalibration of global interest rates as inflation moved (albeit slowly) towards central banks’ targets. While most G7 countries have initiated policy easing, the Fed is rather standing idly by as they thread the needle between inflation and future growth. Last quarter, we noticed cracks starting to emerge in parts of the US economy, increasing the probability of rate cuts over the near-term. Since then, the latest inflation and unemployment data have generally supported those odds. With the gap between job openings and unemployment recently returning to pre-pandemic levels, labor markets appear to have reached a state of equilibrium. As such, we believe that further softening in labor demand could begin to have less desirable implications for the economy. In sectors like manufacturing, retail, and business services, job growth has stagnated, and while employment within the government sector has been exceptionally robust, we think these jobs may be at risk if officials start spending more prudently.

Looking ahead, we expect the Fed will be more inclined to begin monetary easing, hence supporting risk assets into year-end. However, there is still chance that a delayed reaction from policymakers could have more serious consequences for the labor market and give rise to a more volatile regime. Uncertainty from US elections against a backdrop of today’s richly priced markets, is also likely to contribute to some market instability. However, we are confident that our portfolios are well diversified across both strategies and alpha drivers, and therefore, are prepared to withstand any near-term volatility. We are broadly satisfied with our current beta profile, which has increased from last year’s lows.

In Q3, we plan to increase our allocations to Equity Hedged. Our exposure remains focused on structural themes in the technology, healthcare, and energy sectors, where we believe more durable opportunities for alpha exist. Going forward, we expect to have a more balanced approach between buy-and-hold and opportunistic trading managers in light of the risks highlighted earlier. In Credit / Income, we are decreasing our exposure to longer-biased corporate long / credit strategies as we opt to rotate into less correlated, short-duration lending strategies, potentially in areas where banks remain capital constrained.

Within Relative Value, we continue to decrease our exposure to fixed income relative value (FIRV) strategies due to unusually tight spreads. In our experience, this is generally a function of temporary spells of lower volatility combined with pockets of excessive risk-taking. Our high conviction managers in the space have demonstrated patience and strong tactical skills, and as such, we expect them to be liquidity providers should volatility increase and spreads widen from here. In Trading, we continue to hold a core allocation to our most experienced discretionary macro managers. Despite a recent lack of contribution to our performance, we believe this cohort provides attractive convexity, especially in a left-tail event. We maintain a preference for discretionary trading approaches over systematic as we believe the former can more dynamically adjust exposures during regime shifts and geopolitical crisis, serving as a better tail hedge in portfolios. Finally, we continue to find attractive opportunities in energy-related commodities and expect to add new managers to our roster in the near future.

We continue to hold a core allocation with our most experienced discretionary macro managers, although the near-term outlook for developed market (DM) macro managers is somewhat challenged given rangebound moves in rates / rates curves and overall high beta to US rates. Despite this, the potential for increasing divergence across G10 economies / policies could unveil opportunities to trade differentials in both rates and FX. Upcoming elections in the US could also lead to volatility, presenting chances for short-term trading, as well as longer-term structural themes in FX and rates.

For emerging market (EM) macro strategies, the recent sell-off in Q2 has potentially enhanced entry points into rates receivers and certain FX carry traders. We plan to maintain allocations to systematic trading strategies, targeting managers who can provide better diversification through alternative markets or models. Additionally, our focus remains on maintaining our commodity allocations, particularly in gas and power strategies, which are complemented by strategic long positions in the less correlated green materials theme.
 

We continue to seek a balance of lower beta, sector specialists and modestly directional generalist exposures. Despite some expected volatility ahead of the US election, HFS believes that with increasing odds of rate cuts in the second half of the year, the environment is more likely to be supportive for equities. Our exposure maintains focused on structural themes in the technology, healthcare, and energy sectors, where we believe there are more durable opportunities for alpha. Geographically, most of our exposure is linked to the US growth and inflation narrative.

Additionally, we continue to find the opportunity set in Japan attractive. We believe the country is likely to benefit from a virtuous cycle of inflation and growth, heightened by tailwinds from corporate reform. However, our allocation in China remains small. We are still cautious as we await more significant stimulus from policymakers.

Within Relative Value, FIRV remains a core allocation, but we continue to reduce our target weight. Our return expectations remain slightly lower for the strategy as inflation appears to be moderating towards central bank targets in the US/UK/Eurozone, allowing for clearer forward guidance from policymakers. While this should continue to put a dampener on rates volatility, there are some upside risks to volatility in H2, not least the US election and the associated geopolitical and fiscal implications, as well as elevated political risk in the Eurozone. HFS continues to maintain a neutral outlook on quantitative equity strategies, preferring more technical approaches over fundamental. Currently, we are mindful of potential pockets of over-earning / reversion risk and the possibility for overall exposures to trend lower (rather than higher) on higher correlation or volatility.

Our outlook for capital structure / volatility arbitrage strategies remains positive. We believe the 2025-2026 maturity wall will lead to a continued surge in corporate actions and new issuance, contributing to solid returns for the convertible arbitrage strategy. HFS maintains minimal exposure to merger arbitrage strategies. While spreads widened to more attractive levels in Q2, we are being patient to deploy capital. We expect M&A activity to remain subdued as we approach US elections.
 

HFS plans to reduce current allocations to corporate long / short as we opt for more idiosyncratic, carry-oriented opportunities within asset-backed and other income strategies. That said, we still believe that elevated default activity and growing issuer dispersion have resulted in a reasonably fertile opportunity set for corporate long / short credit strategies. In agency MBS, we plan to keep our current allocations, with a focus on mortgage derivative strategies. The relative value spreads remain wide while prepayment speeds remain low, and the majority of borrowers would still be out of the money to refinance even if interest rates were -200 bps lower. Fed rate policy and changing interest rate cut expectations has also continued to create trading opportunities in the mortgage basis.

In reinsurance / ILS, HFS plans to maintain exposure following recent allocations. However, in some portfolios, we are tactically managing exposure and deployment into mid-year contracts following projections of a more active hurricane season and the first named storm landing early. We remain underweight long-biased and distressed. Without a material increase in distress activity or spread widening, the opportunity set remains limited.

Update: As of 5 August, global markets have been experiencing a significant increase in volatility. Last week’s NFP report missed expectations, confirming our worries and triggering a major sell off in risk assets. While we believe investors are now more appropriately pricing in a higher probability of US recession, our views remain broadly intact, particularly around the Fed's ability to respond vigorously to rising unemployment. Furthermore, in our view, the current drawdown could put downward pressure on equity valuations and reduce length in certain segments of the market, potentially creating interesting opportunities for fundamental investing.