Crypto, Taxes & Volatility: A Hedge Fund Watch List For 2018
(Bloomberg) -- Even a new U.S. president and rising geopolitical tensions couldn’t stop stock markets from marching higher. But that’s about to change, money managers say.
They see a market correction, a "reckoning" with North Korea and a bitcoin ETF in 2018. Here are some of the top themes hedge fund firms - and those who invest in them - are looking for in the year ahead:
A pullback in quantitative easing by central banks globally could trigger a downward spiral in asset prices and spell a "significant change" for the macro trading environment, Paul Tudor Jones wrote Nov. 30. He compared the current bull market to the bubble of 1999. Low volatility is becoming "dangerous" and has lulled investors into a false sense of complacency, he wrote. His firm’s main fund lost 2.1 percent this year through Dec 8.
Assets most at risk are those reliant on low interest rates, such as highly-leveraged credit, illiquid securities and those that benefit from momentum trading, including FANG stocks — Facebook Inc., Amazon.com Inc., Netflix Inc. and Google, London hedge fund manager George Papamarkakis said. These companies are "definitely prime for a substantial correction" next year given current valuations, he said.
Volatility spells good news for macro hedge funds and the outlook has renewed interest in the struggling strategy. Investors have moved nearly $15 billion dollars into macro funds this year through September, more than any other strategy, according to data provider eVestment.
Cryptocurrencies are hot. Mike Novogratz started a $500 million hedge fund to invest in the assets and bitcoin futures contracts began trading at Cboe Global Markets Inc. and CME Group Inc. this month. What’s next? Some hedge fund startups plan to offer loans that use the cryptocurrency as collateral, but given the high volatility, expect steep terms.
"I think we will see a bitcoin ETF in 2018," said Jose Suarez, co-founder of $300 million hedge fund Silver 8 Capital, which invests in cryptocurrencies and blockchain startups, and is up more than 800 percent this year through Dec. 19.
"Futures are already giving more legitimacy to the asset class and ETFs will give even more legitimacy, so more institutional investors will make it part of their portfolios. Still, the custodianship issue needs to be solved," he said, referring to security concerns involved with holding the currency.
Yesterday, Congress passed the first major overhaul of the U.S. tax code in decades. Kevin Russell, who runs UBS’s $5.4 billion hedge fund unit, said the legislation bodes well for stock pickers because the changes will impact companies differently depending on their geographic location, net earnings, effective tax rates and the amount of debt they have. That will create greater price anomalies for traders to exploit.
Small and mid-cap stocks may see gains next year with new rules, said Jonathan Hook, chief investment officer of the Harry and Jeanette Weinberg Foundation, which allocates money to hedge funds. That’s because those companies "tend to be higher taxpayers, so their returns should go up since their tax bill should be lowered," he said.
Hedge fund Roubaix Capital, which runs $103 million, agrees. The tax bill will be “the most significant fiscal event” for small-cap stocks for the foreseeable future. A corporate tax cut will create fresh opportunities on both the long and short side. For companies getting a tax break, “less than a third of this benefit is currently priced in,” the Denver, Colorado-based manager wrote in an email this week. For those firms that already pay little or no taxes, the new rules will have little effect on their earnings, “driving incremental short opportunities.”
Europe is looking good to investors. Differing growth outlooks for countries across the euro zone is creating tradable opportunities for UBS’s hedge fund unit. "For example, we see relative mispricings in bank credits with interesting opportunities across banks in Germany, France and Spain," Russell said.
European distressed credit, particularly non-performing loans and non-core asset sales from banks, are top picks for Infinity Capital Partners’ Jeff Vale, who invests in hedge funds. And Brevan Howard Asset Management is betting Greece will bounce back from almost a decade of crisis.
Banks and hedge funds had reduced exposure to Europe this year amid Brexit and other political uncertainty. That, along with a rise in passive investing, has created less active competition in the region, said Man GLG’s Pierre-Henri Flamand. In addition, new European MiFID II regulations will likely create a less-researched market, one that’s ripe for stock-pickers to shine, he said. "It’s fewer people looking at the same investment opportunities," he said. "It should be an excellent environment for long-short money managers."
Banking on Banks
The future is bright for the credit quality of regional banks, says SkyBridge Capital senior portfolio manager Troy Gayeski. Their balance sheets have "ample room" to grow as corporate lending rises and a hike in interest rates could result in higher cash flows. They are also positioned to benefit from merger activity in the industry and the U.S. tax bill, which lowers the levy on corporations. Potential changes to the Dodd Frank financial regulations in the U.S. may also benefit the industry. To seize the opportunity, SkyBridge has ramped up its wager on regional and community bank Trust Preferred CDOs, which are collateralized debt obligations with both equity and subordinated debt-like features.
Banks in peripheral Europe are favored by Oceanwood Capital Management’s Julian Garcia Woods. Spain’s Liberbank has been "unfairly punished" in the wake of Banco Popular’s June collapse, he said. Northern Italy’s Banca Popolare di Sondrio has a strong balance sheet and yet "the baby is being thrown out with the bathwater," Garcia Woods said. The industry is under the microscope of the European Central Bank, so "there is constant fear of equity dilution, even if the underlying economy is strengthening," he said.
Apart from trading ideas, here are key events in the industry for 2018:
In January, hedge fund legend Steven Cohen can once again trade client capital. He was banned after his former hedge fund pleaded guilty to criminal charges and paid a record $1.8 billion in penalties. (Cohen himself was not charged with any wrongdoing.) Terms for the potential new fund are already raising questions among some investors. The new year is expected to bring clarity on whether investors will jump in or see the price-tag as simply too steep.
Other firms to watch: Jones’s Tudor Investment Corp., Paulson & Co., Caxton Associates and Brevan Howard. It’s been an especially painful year for these funds, which have seen assets plunge and performance wither. Jones shuttered one of his firm’s funds in November and Andrew Law’s Caxton is grappling with one of the worst losses in the macro-trading universe this year. The chiefs of both funds are betting if they manage more of the money and risk themselves, it will help turn things around.
Geopolitical tensions remain an over-arching question mark that could change the course of trading quickly.
The new year could bring a “sort of reckoning with North Korea,” said the Weinberg Foundation’s Hook. Michael Hintze, who runs credit-focused CQS, cited strained relations with the nation as one 2018’s "potential potholes." For Russell, tensions with the Middle East appear to be the market’s "mini blind spot."
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