By Kevin Hurd and Steve Togher for Cross Shore Capital Management
Equity markets rebounded sharply in the first quarter following a pivot by the Federal Reserve to a more dovish stance and an easing of global trade tensions. The S&P 500, Nasdaq, and Russell 2000 indices rose 13.6%, 16.5%, and 14.6%, respectively, for the quarter, making back most of the losses from a dismal fourth quarter of 2018.
Long/short equity hedge funds rebounded strongly as well with the average fund up 7.9% for the quarter (HFRI Equity Hedge (Total) Index). Generally, we saw relatively high long-short spreads across the group, with meaningful alpha generation in short portfolios, meaning that although short positions tended to lose money, they did not appreciate nearly as much as the market did.
January was one of the best months for equity markets since the financial crisis. The S&P 500 was up 8.0% on the month. Long/short equity hedge funds also performed well, up 5.1% on average. Managers were able to take advantage of the December dip and add to high conviction long positions as well as build new long positions in companies they admire but previously believed the stocks were not attractively priced. Many of these positions rallied strongly during January, generating significant alpha.
In the latter half of the month, we saw managers taking profits on the long side of their portfolios and adding to short positions in weak companies that had been riding the coattails of the market rally.
However, towards the end of the month, we also saw managers adding to last year’s best performers, predominantly in the Technology and Healthcare sectors, which generally paid off well in February.
The equity market rebound continued in February and long/short equity hedge funds performed well again as well. The S&P 500 returned 3.2% for the month while long/short equity hedge funds returned 1.9% on average. We saw managers trimming US exposure during the month and adding to positions in Europe and Asia. Technology and Healthcare sector focused managers performed the strongest, up 3.4% for the month on average (HFRI EH: Technology/Healthcare (Total) Index).
March was a choppy month for equity markets although the S&P 500 ultimately finished the month in the black, up 1.9%. The average long/short equity hedge fund returned 0.5% in March. Many managers were able to take advantage of the intra-month volatility and generate significant alpha on the short side of their portfolios. Managers continued to trim US exposure and add to exposures in Europe and Asia.
Managers with significant exposure to small-cap equites struggled as the Russell 2000 was down 2.1% for the month. Managers with significant exposure to financial services sector stocks also struggled as the S&P 500 Financials Index was down 2.6%. Toward the end of the quarter we noted generalist managers reducing technology exposure (which had risen close to October 2018 highs) in favor of healthcare services, including hospitals and managed care.
The quarter ended with gross exposure levels having generally returned to pre-sell off levels. However, net exposure levels largely have not. While most managers we speak with are optimistic in the near-term, they are also cognizant of potential pitfalls on the horizon. For example, the yield curve temporally inverting during the quarter, which is historically a good indicator of an upcoming recession.
In addition, while economic statistics continue to point to a strong US economy, the market could price in a return to rate hikes if economic growth continues above expectations, coupled with a pick-up in inflation. Lastly, a hiccup in the trade negotiations between the US and China could also spark a broad sell off.
Given these variables, Cross Shore continues to believe that a hedged strategy is the best way to materially participate in rising markets while providing downside protection.