Just three months ago, we assessed that the investment climate was best characterized by high economic uncertainty, increased geopolitical risks, elevated valuations and tight credit spreads. Fast forward to today, both economic uncertainty and geopolitical risks are even HIGHER, valuations have begun to recede and credit spreads are widening. However, Warren Buffett is not on a buying spree and the credit world is not distressed, YET. One could argue that US President Trump set these animal spirits in motion; others would say that the world order is being upset over a long cycle (Ray Dalio) and others are pointing to unsustainable levels of debt. Regardless of the exact reason, we expect sustained market volatility and dispersion, fleeting liquidity during surprise news announcements and crowded unwinds. From a hedge fund active investment management point of view, this environment provides both auspicious opportunities and large risks. We expect to see larger divergences in manager performance within the same sector due to increased volatility. Investors need to be diversified, liquid, opportunistic and patient.
Strategy highlights
- Relative value: Increased volatility and dispersion are creating a better opportunity set for relative value strategies that may be able to capitalize on pricing inefficiencies within and across asset classes.
- Discretionary global macro: Policy implementation may help establish market trends and themes in the coming months, creating potentially attractive opportunities for forward-looking managers.
- Commodities relative value: Trade policy announcements have helped create geographic arbitrage opportunities, though headline risks abound as macro factors are likely to continue to be a key driver of commodity prices.
|
Strategy |
Outlook |
|
Long/short equity |
Neutral with a preference for equity market neutral approaches given a cloudier beta picture but a compelling alpha environment. Volatility often challenges returns in the near term but can also create attractive entry points. |
|
Relative value |
Neutral but improving outlook due to higher political and economic risks, creating increased opportunities for volatility and dispersion within and across asset classes. |
|
Event-driven |
Modest downgrade in outlook due to a generally limited opportunity set for event-driven investing prompted by higher uncertainty and low confidence creating a dearth of corporate activity for now. |
|
Credit |
Remain underweight directional strategies due to tight spreads and potentially higher economic risks. Still favoring the long/short credit investment approach, which may benefit from active shorting and dynamic exposure management. |
|
Global macro |
Shifting from policy announcement to policy implementation may help establish new trends and themes across markets. Discretionary traders with a forward-looking and tactical view may benefit in this environment while some events and policy announcements still pose risks. Relative value trading may benefit from increased regional dispersion and price dislocations across asset classes. |
|
Commodities |
The relative value opportunity set appears attractive, though some fundamental strategies may continue to be challenged by risks around binary geopolitical and global trade headlines. |
|
Insurance-linked securities (ILS) |
Cat bond issuance has been strong. This momentum has persisted through the end of last year and is likely to continue into the next quarter as large sponsors are expected to return over the coming weeks. The market remains healthy and has exhibited some firmness as of late regarding spreads, as deals have priced within or higher than initial guidance in addition to getting upsized. |
Macro themes we are discussing
Just three months ago, we assessed that the investment climate was best characterized by high economic uncertainty, increased geopolitical risks, elevated valuations, and tight credit spreads. Fast forward to today, both economic uncertainty and geopolitical risks are even HIGHER, valuations have begun to recede, and credit spreads are widening. However, Warren Buffett is not on a buying spree and the credit world is not distressed, YET. One could argue that US President Trump set these animal spirits in motion, others would say that the world order is being upset over a long cycle (Ray Dalio), and others are pointing to unsustainable levels of debt. Regardless of the exact reason, we expect sustained market volatility and dispersion, fleeting liquidity during surprise news announcements, and crowded unwinds.
Given that the current market environment can still be characterized by high economic uncertainty, increased geopolitical risks, elevated valuations, and tight credit spreads, even with the hints of changing tides we noted above, we continue to believe the outlook for hedge fund strategies is very favorable. These factors are expected to lead to higher volatility across asset classes and increased dispersion within various sectors, particularly as political and economic influences impact sectors differently. This environment is particularly favorable for both relative value and active strategies that can be appreciated from being dynamic, non-directional, and agile.
We are optimistic about discretionary global macro strategies due to geopolitical uncertainty, changing interest rates, and shifts in foreign exchange rates. Relative value strategies appear promising, leveraging corporate events and asset class dispersion. Volatility and risk-mitigation strategies also offer potential insulation and diversification from traditional market risks.
Flexible hedge fund strategies that can take advantage of these market conditions have the potential to create significant opportunities for savvy investors.
Q2 2025 outlook: Strategy highlights
Relative value
Relative value strategies have an advantage over directional investment styles at a time when the likely direction of markets is harder to predict. This challenge is particularly pronounced during inflection points. When there is a high degree of policy and economic uncertainty, there are strong tailwinds for some assets, and potentially excessive valuations for others. These uncertainties are beginning to be realized in the pricing of volatility across major asset classes, as can be seen in the following chart. While volatility is generally considered a risk factor for directional strategies, it in fact may present opportunities for managers that can capitalize on it through active trading in strategies such as volatility arbitrage, convertible bonds, and fixed income relative value.
Exhibit 1: Citi's Global Risk Factor at Highest Level Since 2022
January 1, 2022 to March 14, 2025
Source: Citi. As of March 14, 2025. Important data provider notices and terms available at www.franklintempletondatasources.com.
Discretionary global macro
Many macro traders have begun to question the US exceptionalism theme that has prevailed for many years. General policy uncertainty in the United States and a relatively dramatic shift in fiscal policy in Europe have been some of the many catalysts for some investors to begin shifting their portfolio allocations between regions. A rebalancing from the last few years’ winners toward the laggards could have important implications for global equities and foreign exchange (FX) markets. The recent outperformance of European equities and FX markets reflect some of that shift, though there is still some uncertainty as to whether this is the beginning of a long-term trend or a short-term move. Regional dispersion like this can be a boon for many macro managers, and the prospect for ongoing shifts in macro policy could help create an attractive opportunity set going forward.
Exhibit 2: US vs. Europe Equity Performance
December 30, 2022 to March 21, 2025
Source: MSCI. As of March 21, 2025. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results. Important data provider notices and terms available at www.franklintempletondatasources.com.
Commodities relative value
Changes in trade policy have been an important driver of commodity prices recently. The expectation for, or announcement of, various tariffs has helped create interesting divergences across markets. Copper prices have rallied recently for a variety of reasons, but it is the widening spread between US and UK futures markets that has captured the focus of many relative value traders. The two markets can have minor divergences at any given time but have historically traded relatively closely in line. The unusually wide spread reflects surging demand for the metal in the United States before tariffs are implemented or even formally announced. A relative value trader betting on tariffs could have profited from taking long positions in Comex1 copper in the United States and offsetting shorts in London Metal Exchange (LME) copper in the United Kingdom. Some managers may view the unusually wide spread as an opportunity for mean reversion, placing bets that the prices will converge again in time. Going forward, the rapidly evolving global trade landscape may continue to create a fertile opportunity set for commodity traders, even without taking significant directional risk.
Exhibit 3: Comex vs. LME Copper Performance
December 29, 2023 to March 21, 2025
Source: Bloomberg. As of March 21, 2025. Past performance is not an indicator or a guarantee of future results. Important data provider notices and terms available at www.franklintempletondatasources.com.
Endnote
- COMEX (Commodity Exchange, Inc.) is a division of the New York Mercantile Exchange, which is now owned by CME Group, the world's largest commodity exchange operator. It is a market for trading futures and options contracts on metals like gold, silver, copper, and others.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results. Some subadvisors may have little or no experience managing the assets of a registered investment company. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Derivative instruments can be illiquid, may disproportionately increase losses, and have a potentially large impact on performance.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default. Currency management strategies could result in losses to the fund if currencies do not perform as expected.
Commodity-related investments are subject to additional risks such as commodity index volatility, investor speculation, interest rates, weather, tax and regulatory developments. Short selling is a speculative strategy. Unlike the possible loss on a security that is purchased, there is no limit on the amount of loss on an appreciating security that is sold short. Investments in companies engaged in mergers, reorganizations or liquidations also involve special risks as pending deals may not be completed on time or on favorable terms. Liquidity risk exists when securities or other investments become more difficult to sell, or are unable to be sold, at the price at which they have been valued.
Active management does not ensure gains or protect against market declines.