Catella Hedgefond – Chaos theory maintains that a butterfly flapping its wings can generate a storm on the other side of the world.

The Covid-19 crisis has created a perfect storm, with almost all assets negatively impacted and also correlating with each other. Very few asset classes or portfolio management approaches have lived up to the expectations placed on them during the past month, and this unfortunately also applies to Catella Hedgefond.

The fund has fallen considerably in March, around 15 percent. What is the explanation for this steep fall, and how can a fund in risk category 3 be impacted so negatively?

First, a few words about the fund's strategy

Catella Hedgefond employs a number of different strategies to manage risk levels and return targets. When it comes to our equity strategies, we buy shares we believe in and short shares we do not believe in. In theory, this means that when we own equal parts long holdings and short holdings (short selling), we do not take any market risk. In other words, our exposure is not intended to participate in any general directional trend, either a stock market upturn or downturn. But we still take what is called stock-specific risk. This is the risk associated with the performance of the companies we own or short, not how the stock market performs. In addition to this, we invest in interest-bearing securities, partly through an actively managed basket of corporate bonds intended to generate a higher current yield, and partly through a very large basket of capital invested in cash and cash-like assets such as government bonds that offset the risk taken in corporate bonds. Overall, these equity and bond strategies should generate a good risk-adjusted return over time.

If we take a closer look at what has influenced the fund in March, we can see that simply all assets have fallen sharply. The stock market has fallen exceptionally quickly, and volatility has been at record-high levels. This should not be what governs an equities strategy that takes little market risk. However, the shares we held in our portfolio were adversely affected during the month due to our view of valuations, which led to the difference between our holdings on the long and short sides also adversely affecting returns. Alongside this, interest-bearing securities with previously relatively low risk levels have been affected by price declines, and bonds in the high yield (HY) segment were severely impacted during the period. This has led to a steep decline in the value of the portfolio. Throughout March, we have adjusted the portfolio's risk and tried to position ourselves so that we come out of this perfect storm with a portfolio that can grow going forward.

The following is a more specific review of the impact of the various parts of the portfolio.

Fixed income securities

Catella Hedgefond's fixed income element consists of an engine of HY bonds that over time provides a higher current yield. This element has been combined with a high proportion of liquid assets in the form of cash and cash-like instruments such as government and housing bonds.

At the beginning of the crisis, the fixed income portfolio in the fund was positioned for rising interest rates. With the help of derivatives, we had ensured that the fund had a slightly negative interest rate duration. We based this analysis on the then-negative market interest rates in combination with the Riksbank having an increasingly hawkish stance. This was before the black swan coronavirus became a reality for us. We closed this negative-duration positioning immediately when investors began to reallocate to government securities in the wake of the coronavirus, which led to falling yields. This had a negative impact on the return of about 1 percent, and the interest rate duration rose to around 1.5 years.

When we entered the crisis, there was no hedging in the fixed income portfolio. This hedging is often included in the portfolio in the form of, among other things, purchased put options on OMX. This is a kind of insurance, where we buy options with the right to sell at a stock index level that might be 5-10 percent below the index at the time of investment. If the stock market falls steeply, the options become valuable and thus provide protection. If the stock market rises instead, the options become only a cost to the portfolio management that might be compared to an insurance premium. All corporate bonds, high yield bonds, dropped significantly in value, with the result that credits spread widely apart. The European Itraxx Crossover credit index moved from 200 basis points to 750. This re-pricing of high yield has had a negative impact of approximately 3 percent on the portfolio's return during the period.

Preference shares

The fund owns a number of preference shares that provide a good current yield, and where co-variation with stock market is normally relatively low (normally beta 0.1-0.2). But as we mentioned above, most assets moved towards a correlation of 1 in March. Preference shares have been traded and priced in the past weeks as if they were common stock, and beta has been closer to 0.7. We have lost about 3 percent in returns in this mandate.

Shares – Long / Short

Throughout 2019 and into 2020, Catella Hedgefond's long/short equity holdings have focused on investing in undervalued companies in the long portfolio, and the equivalent overvalued companies in the short portfolio. Unfortunately, this strategy has generated a negative return over the period. As it turns out, the market has continued to favour those shares that were more expensive and has further pushed down the prices of undervalued stocks. For example, value-oriented equities have fallen about 44 percent between the turn of the year and March 20, while the companies with higher valuations, often referred to as quality shares, have seen their prices drop by about 12 percent this year. The reason for the extremely low figure of 12 percent is that they continued to rise strongly in January, while value-oriented equities fell at that time. The equity portfolio managers continue to have a similar mix of exposures. As the crisis has escalated, companies with low valuations have lost more ground in the market than those with high valuations, resulting in us losing around 8 percent in the long/short mandate in March. This is despite the fact that we have reduced the total amount of portfolio holdings, gross, and have made some repositioning. This is a highly unsatisfactory outcome for the fund, which in principle was market neutral and which, according to analysis and risk measurements, has previously functioned as uncorrelated in the market. We were lulled into a false belief that the fund was indeed uncorrelated with the stock market before the crisis took off. This goes to show that a black swan really is a black swan! On the long side, we have some large positions in mid-cap companies, which have been hit extremely hard. Liquidity has disappeared in many of the smaller companies over the past two weeks, resulting in substantial price movements. When the stock market has then taken an upward bounce during a correction, the large liquid companies have kept up but risk appetite has not yet fully returned for the smaller ones. In recent days, however, we have been pleased to see tendencies towards some recovery even for smaller companies.

It is little comfort that Catella is not alone in these outcomes, and the misfortune is shared by large numbers of fund managers. For many years, Goldman Sachs has created a compilation that shows the relationship between two baskets of stock. One basket contains the long holdings that are most popular with US hedge funds, and the other contains the short holdings that are most popular with the same funds. The compilation reflects how an average long/short American hedge fund has behaved. The conclusion is that, in March, it has had the most dramatic loss of returns ever, at -17 percent (March 20, 2020).

Could we have bought index hedging in Catella Hedgefond? Yes, but that would have meant no longer striving to achieve a market-neutral fund and instead taking a bet on the direction of the market. The concept since 2016 has been for a more market-neutral fund, with an ambition for low correlation with the market. Once the crisis became a fact, the price of hedging became far too expensive after only one or two days. In some cases, it was not even possible to short certain companies. It was simply not possible to borrow shares to short.

In the Nordic market, we can look at different sectors and segments of the stock market and find that value-related shares that ought to do better in a weak market are among the real losers. Collectively, they have lost around 44 percent in trading compared to the Stockholm stock exchange, or against an index that has lost over 25 percent in the same period (March 20, 2020).

To conclude

Both central banks and governments are now doing everything in their power to cushion the economic impact. This will by extension dampen the increase in demand that comes in the wake of a "shutdown" of the economy. The dramatic events in the markets, with large parts of the credit market more or less closed and the fastest and sharpest stock market slides ever, will calm down in the near term. The long-term effects will largely be a function of how long the spread of infection continues. The longer the economy is closed, the more companies and individuals will "run out" of money. Our best assessment is that Europe will follow the course of events we have seen in China, which means the market will take on board the rate of increase in the number of new cases and the numbers of deaths. Investment grade credits, which we have long considered far too expensive, have now reached a level where the potential for satisfactory returns in the future is good. Companies with lower credit ratings, the high yield issuers, have also been heavily repriced, and from here on it will be important to try to avoid default situations. We believe that the coming months will see greater spreads between high yield bonds. As long as they are able to pay the coupons, there is solid potential for good returns, but many of these companies are likely to have trouble paying their interest and there will have to be restructuring. A rough estimate is that we have a current yield in our high-yield portfolio of just over 10 percent at the moment. The stimulus packages being launched will lead to large budget deficits and will be financed with government bonds. Central banks will buy up much of this debt through QE, so we do not anticipate dramatically rising long-term interest rates ahead. What has been a concern for us for some considerable time has been the stock market's failure to consider valuations. Expensive companies have become more expensive and cheap companies cheaper. We anticipate that valuations will come back into focus, in the same way that they were the deciding factor for stock returns after both the dotcom crash in 2000 and the most recent financial crisis in 2008. One factor to support this would be the general downward trend of interest rates levelling out or even rising slightly given the growing budget deficits that we will see. That being said, our opinion is that our portfolio is well placed to deliver a good return in the coming years, although we are obviously both disappointed by the performance in recent weeks and alert to what the future might bring.

We at Catella Fonder are of course available by phone or email if you have any questions / concerns.

Read: 

Mid-crisis – what can people do with their investment portfolio?

Catella Hedgefond: Two weeks into March 2020 – at the epicentre of Covid-19!

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Catella Hedgefond

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