Morgan Stanley IM: 2024 Midyear Outlook - Hedge Funds

KEY POINTS

1. The first half of 2024 was a particularly strong period for alpha generation across the hedge fund landscape. Fundamentals have become increasingly important as macro factors have had a decreasing impact on asset level returns. We remain constructive on the environment for alpha generation and expect the latter half of 2024 to offer rich opportunities across a number of strategies.
2. Markets must grapple with a number of uncertainties from now through year end: elections, diverging central bank policy and geopolitical tensions top the list. Each of these has the potential to influence markets, driving both volatility and opportunity.
3. While our optimism for alpha generation remains strong, we are cautious with respect to equity and credit beta. Valuations remain stretched while a growing list of uncertainties give us pause in adding directionality to our portfolios, aside from the more flexible and tactical positioning of global macro. We maintain a preference for market neutral, relative value and macro, with managers able to drive alpha from both long and short positions through low correlation portfolios.
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What We're Seeing
At first glance, the first half of 2024 felt like a continuation of the 2023 market environment: equity indexes posted strong returns, but leadership was concentrated in just a handful of technology shares, uncertainty around the path and timing of central bank policy remains, and geopolitical and election related uncertainty has driven bouts of volatility, especially of late. Meanwhile, a resurgence in asset price dispersion at the security, sector and country level has created abundant alpha opportunities for hedge funds in 2024, supported by dynamics that we expect to persist for the remainder of the year.

Fundamentals have increasingly driven stock prices in 2024 with micro-level drivers accounting for the majority of price changes, as opposed to the more macro-driven environment that persisted during 2022 and much of 2023. We see further evidence of the fundamentally driven environment in the performance of the short interest factor, which has declined significantly year to date, as fundamental performance has driven declines in heavily shorted stocks. In credit markets, significant progress has been made towards reducing a looming maturity wall. Spreads remain tight with low volatility, however, which may potentially limit directional upside from here.

We expect policy divergence across global central banks to provide greater opportunity to express country-specific views on growth, inflation, and long-term neutral rates both within and across yield curves. Political uncertainty has moved to the forefront, and is not isolated to the U.S., as policymakers throughout developed and emerging economies look to address respective social, demographic, and geopolitical issues. There also remains material risk associated with heightened geopolitical tensions, including the risk of proliferation of war across the Middle East. Each of these dynamics has myriad impacts across the opportunity set for global macro strategies.

What We're Doing
Across the board, we generally remain constructive on alpha factors, while exhibiting some caution on beta. Within equity markets, we believe that alpha opportunities from security selection will remain heightened, benefiting long/short managers. We maintain a preference for lower net or market neutral managers with the ability to generate alpha from both long and short positions. Notably, beta exposure has been a poor indicator of year to date returns in the fundamental equity long/short space, as higher net exposures have not necessarily translated into outsized returns, despite the strong returns at the index level. In particular, the quant equity space stands to benefit further from the supportive environment for stock-picking, with perhaps the greatest opportunity in mid-frequency and fundamentally driven quant equity strategies. Faster moving statistical arbitrage models may see opportunities increase in coming months should overall market volatility increase.

In credit markets, we increasingly favor tilting exposure in favor of low-beta relative value expressions that are more likely to benefit from an expansion in volatility, but we note that returns may be more muted in the near term given low current levels of volatility and tight spreads.

Within macro strategies, we currently prefer discretionary to systematic, given an uncertain outlook for major price trends combined with lower overall levels of volatility at present. We expect to see an expanding opportunity set for global macro over the coming quarters, as political, fiscal and monetary policy uncertainty should create opportunities for macro strategies to capitalize on novel trends across major markets, as well as build more nuanced portfolios.

In summary, we remain constructive on the environment for hedge funds as we believe the current market and macro dynamics, which have resulted in increased alpha production, should persist for the balance of this year and beyond.