Outlook for 2018 – Inflection Point in Global Liquidity

January 22, 2018

If we have to name one defining element that has held back hedge fund returns in recent years, it is the enormous glut of liquidity that has been lifting all boats. It has made it almost impossible to achieve positive absolute returns from shorts, something clearly reflected in our portfolio as none of our managers made positive returns on the shorts in 2017 (on a relative basis they did quite well with decent alpha long and short). And it has made fundamental global macro investing very tough, resulting in our global macro funds reporting a small loss on average in 2017.

What excites us for 2018 is that 10 years after central banks embarked on the path of quantitative easing, 2018 will be the first year that the combined central banks will withdraw liquidity from the system, i.e. the Fed balance sheet reduction will more than offset the liquidity injections by the ECB and BOJ. On top of that most of our managers expect inflation to pick up. Liquidity withdrawal and higher rates we expect to have the opposite effect from the consistent compression of risk premiums across all asset classes that we have seen the last 10 years. The wave of liquidity has postponed the day of reckoning for many of the companies our managers are short, but that also implies that the moves when this day arrives could well be even more violent. And similarly, while our macro managers suffered, the extreme low level of interest rate volatility for example has allowed them to position for, at a relatively low cost, for a pickup in rates and inflation several years out. Risk premia across asset classes are likely to increase with the withdrawal of liquidity, creating better long-short opportunities in equity and credit markets

If we look at the different strategies of Legends Fund:

Global Macro

Probably the most impacted by a change in global liquidity. We expect a lot of money to be made once rates and term premiums move higher.

Long-Short Equity

While we are not trying to predict a market correction anytime soon, we do believe there is a lot of pent-up performance in our managers’ short positions and we are moving closer to the day that this will materialize. Legends Fund’s long-short equity managers are carrying substantial short books which should help them to outperform when volatility picks up.

Event Driven

This is the category of managers that would seem most at risk when we enter a more difficult environment for general markets given their current net long positioning. However, as mitigating factors, these managers invest around idiosyncratic events that are less correlated with the general markets. Also, they will reduce their long books once they feel the environment becomes less supportive to equity markets. And volatility would create interesting opportunities in credit markets that have been lacking for several years, absent the distress in energy markets in 2015/2016.

Relative Value, Credit and Quant

This is a bit of catch-all bucket. It has low overall net market exposure and would generally profit from more dispersion.

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