Market Neutral L/S struggles as momentum stocks take a hit

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Risk assets failed to reach a bottom early December despite the U.S and China agreeing to negotiate on trade
at the G20 summit. The near-term outlook remains unclear from political uncertainties, which prevent investors
from adding risk in portfolios despite lower equity valuations and wider credit spreads. Going forward, the
Federal Reserve (the “Fed”) meeting from December 18th – 19th will be critical to gauge whether its stance has
effectively turned less hawkish after recent comments in that direction from FOMC voting members. We think
the Fed will adjust its stance, and now expect two rate hikes in 2019 vs. three in the Fed dot plot at present.

The dynamic in the hedge fund space throughout November remained similar to October’s, though the damage
was far more limited. Merger Arbitrage outperformed while L/S Equity and Special Situations strategies
underperformed. L/S Credit strategies remained pretty much resilient despite widening high-yield credit spreads
in the U.S. and Europe.

Market Neutral L/S Equity strategies were one area of disappointment in November. The strategy
underperformed as momentum stocks suffered another hit. We have long highlighted the sensitivity of the
strategy to the momentum equity risk factor over the long run.
Our estimates suggest that such sensitivity, which
was limited in early September, has risen markedly since then (see charts below). Based on a sample of 35 L/S
Equity Market Neutral UCITS strategies, the median performance was -1.6% in November, the worst was -9.1%
and the best was 4.1%. Only 17% of the strategies in our sample were in positive territory last month. Digging
into the roots of the momentum’s headwinds, we observe that it has been highly vulnerable to the reversal in
Technology stocks. Finally, our views on the Market Neutral L/S strategy have been somewhat
defensive. We maintained a neutral stance on the strategy throughout the year. Our lack of enthusiasm for the
strategy reflects its perpetual vulnerability to momentum reversals. At the same time, we haven’t recommended
an outright underweight stance, due to the benefits of low beta strategies in the current environment. Our stance
remains unchanged with a bias towards an upgrade at a later stage, as risk appetite is likely to remain limited
in 2019.