Key Takeaways
- • March 2020 fixed income market dislocations created stark performance divergence among hedge fund managers employing similar strategies across structured credit, corporate credit, distressed, high yield, CLOs, convertible bonds, and relative value fixed income.
- • Managers who pursued "reaching for yield" strategies with excessive leverage and higher-risk securities outperformed in 2019's low-volatility environment but suffered severe drawdowns when the market repriced, exposing clients to unacceptable tail risk.
- • Portfolio stress testing revealed that diversification assumptions broke down during the selloff as correlations spiked and liquidity evaporated across non-Treasury fixed income securities—replicating dynamics from the 2008 financial crisis.
- • The dislocations created substantial alpha generation opportunities for disciplined managers through security selection, while simultaneously reshaping competitive positioning across the hedge fund industry.
Summary
The March 2020 fixed income market dislocations created a significant performance divergence among hedge fund managers that will fundamentally reshape competitive positioning across the industry, according to Don Steinbrugge, Founder and CEO of Agecroft Partners. The first-quarter selloff affected virtually all fixed income hedge fund strategies, including structured credit, corporate credit, distressed, high yield, CLOs, convertible bonds, and relative value fixed income strategies.
The market stress functioned as a real-life stress test that exposed managers who had subjected client portfolios to unacceptable risk through excessive use of leverage and concentration in higher-risk securities. Many of these underperforming managers appeared attractive during 2019 when volatility remained suppressed and interest rates and credit spreads continued their decline. Their strategy of reaching for yield to boost returns masked underlying portfolio vulnerabilities that materialized once market conditions shifted.
The poorest-performing managers fundamentally misunderstood the behavior of portfolio correlations during market stress events. These managers believed diversification across fixed income holdings would meaningfully reduce downside volatility, overlooking lessons from the 2008 financial crisis when liquidity dried up and correlations spiked across non-Treasury fixed income securities. Securities with lower liquidity, longer durations, and lower credit quality were hardest hit. The recent performance drawdowns experienced by these lagging managers significantly exceeded what most of their investors had anticipated or modeled.
The dislocations simultaneously created one of the most favorable environments for disciplined hedge fund managers to generate alpha through superior security selection. This market dislocation separated managers based on portfolio construction discipline and risk management rigor, fundamentally altering the relative attractiveness of various fixed income hedge fund strategies for institutional allocators going forward.
The market stress functioned as a real-life stress test that exposed managers who had subjected client portfolios to unacceptable risk through excessive use of leverage and concentration in higher-risk securities. Many of these underperforming managers appeared attractive during 2019 when volatility remained suppressed and interest rates and credit spreads continued their decline. Their strategy of reaching for yield to boost returns masked underlying portfolio vulnerabilities that materialized once market conditions shifted.
The poorest-performing managers fundamentally misunderstood the behavior of portfolio correlations during market stress events. These managers believed diversification across fixed income holdings would meaningfully reduce downside volatility, overlooking lessons from the 2008 financial crisis when liquidity dried up and correlations spiked across non-Treasury fixed income securities. Securities with lower liquidity, longer durations, and lower credit quality were hardest hit. The recent performance drawdowns experienced by these lagging managers significantly exceeded what most of their investors had anticipated or modeled.
The dislocations simultaneously created one of the most favorable environments for disciplined hedge fund managers to generate alpha through superior security selection. This market dislocation separated managers based on portfolio construction discipline and risk management rigor, fundamentally altering the relative attractiveness of various fixed income hedge fund strategies for institutional allocators going forward.
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