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K2 Hedge Fund Strategy Outlook

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K2 Hedge Fund Strategy Outlook K2 HEDGE FUND STRATEGY OUTLOOK Q1 2021 Q1 2021 Outlook: Summary Going into the new year, we are very Strategy Highlights optimistic about the opportunity set, Long/Short With risk in the United States mitigated by the recent positive COVID-19 and we think that active management Equity— vaccine news and the 2020 presidential election results, domestic alpha will be key to success in 2021 International equities have risen to record valuations. Uncertainty that once clouded as beta-driven momentum slows the United States is similarly presenting attractive dispersion opportunities given potentially stretched valuations. internationally, and we believe lower valuations should provide more We believe it is prudent to be growth- downside support. oriented in our portfolio positioning Macro— The strategy may be supported by positive tailwinds of rebounding while also holding hedged alternative Emerging growth and policy support, as well as increased dispersion at the region, investments that exhibit low correlations Markets country and asset class levels within emerging markets. to broader risk assets. Insurance- Higher-than-average insured losses due to COVID-19 and natural Linked catastrophe activity is lifting reinsurance pricing. The market offers Securities (ILS) attractive ILS spreads as we enter the lower-risk period prior to the next hurricane season. Strategy Outlook Long/Short Equity Long/short equity managers have been resilient on a year-to-date basis. While stocks are trading at high valuations, we believe there are still asymmetric dispersion oppor- tunities that could lead to incremental alpha generation in particular areas of the market. Relative Value Favorable outlook for volatility arbitrage and convertible arbitrage strategies driven by persistent inefficiencies in pricing among various asset classes. Negative outlook for fixed income arbitrage based on depressed volatility due to excess central bank liquidity. Event Driven Neutral outlook for merger arbitrage, as spreads for “safe” deals have been tightening. Attractive opportunity set remains in the more complex merger situations as well as special situations equity and credit investing where manager experience is more likely to produce superior outcomes. Credit Long/short credit managers are increasingly focused on event-driven situations given low yields and tight spreads. Uncertainty in structured credit may lead to high levels of dispersion at the instrument, market and manager level. Global Macro As the macro shocks of the last year appear to be normalizing, fundamental dispersion between regions, countries and asset classes may become an increasingly important driver of returns. Managers focused on this dispersion, particularly within emerging markets, may benefit from a rich opportunity set in the year ahead. Commodities The global economic recovery is supportive of increased commodity demand across sub-strategies. As supply-demand tightens into 2021, volatility is expected to increase and favor relative value strategies. Insurance-Linked Both insurance and reinsurance pricing trends are positive as higher-than-average Securities (ILS) natural catastrophe insured losses, broader industry COVID-19-related losses and low interest rates result in higher pricing across the sector including ILS strategies. This outlook is provided to you for informational purposes and is not intended for redistribution. It shall not constitute an offer to sell or a solicitation of an offer to buy an interest in any investment product or fund. This outlook discusses strategies that are available through a variety of structures such as separate accounts, mutual funds and private funds. Not all structures are available for all strategies shown. Interests or shares of an investment fund are offered only through the fund’s offering documents, such as a Prospectus or Confidential Private Offering Memorandum. For Institutional/Professional Investor and Consultant Use Only—Not for Use with Retail Investors. 2 Hedge Fund Strategy Outlook—Q1 2021 Macro Themes We Are Discussing Will inflation expectations continue to rise given companies are disparately dependent on a speedy recovery. We vaccinations, global financial conditions and expected expect that the bigger, stronger companies will be very active in economic growth? strategic business dealings to further strengthen their advantages The start of 2021 offers a new beginning in the sense that the over weaker competitors. economic slowdown due to COVID-19 appears to be coming Will emerging markets recover faster than developed to an end. Individuals and corporations have been buoyed markets? by enormous stimulus from governments, and for the most If the global recovery is strong and fast, commodities should part, have weathered the storm of 2020. Structural trends of experience dispersion due to supply/demand dynamics, and e-commerce, deglobalization of supply chains, health care, emerging market (EM) risk assets could follow suit. That is security, software and sustainability were accelerated due to the especially true in countries exporting commodities and those that economic environment and global lockdowns. have already dramatically devalued their currency. Additional Going forward, if economic growth, earnings and sentiment fuel to these dynamics would be a weakening US dollar. Finally, overreact to the upside in speed and magnitude, inflation will global yield hunters should be enticed by the developing inevitably surface. However, we could have a period of reflation market’s yield premium in fixed income. As a result, we find both without inflation, which would be very favorable for equities. EM equities and foreign exchange attractive on a relative- Conversely, there are many paths to a derailing of the recovery valuation basis. such as failed vaccination implementation, a mutated virus, a With that said, investors do have to be selective in EMs due to sustained second wave or even another global lockdown. challenges of operating in these countries. EM companies face Currently, the markets are quickly moving to price in perfection, challenges from foreign companies entering their markets, reflation with minimal inflation and a robust global economic ongoing global trade tensions, and vaccination distribution recovery. We expect challenges to this pricing to arise periodically challenges. In addition, fiscal and monetary stimulus has been led over the course of 2021, keeping volatility and dispersion elevated by developed markets relative to EM counterparts. and creating rich opportunities for active management. Summary for 2021 Will the global chase for yield continue but deemphasize As we enter 2021, we are very optimistic about the opportunity sovereign fixed income in favor of alternative yield products? set while recognizing that our views are based on a swift Many assets are priced to a flat forward curve, putting a high global recovery that is becoming consensus among allocators. premium on forward cash flows. If the forward curve were Our underlying hedge fund managers are identifying many to rise (steepen), a repricing downward of these duration assets opportunities, both on the long and short side, and think that would be expected in 2021. Given that real interest rates are active-management alpha will be key to success in 2021 historically low, we expect sovereign fixed income to be as beta-driven momentum slows. With data throughout the year, challenged and for interest rates to eventually rise. Investors that we will be constantly challenging our own thinking and making are yield- and income-centric will most likely have to rotate into adjustments as necessary. As a result, we believe it is prudent alternative yield products such as ILS that provide yield for to be growth-oriented in our portfolio positioning while also holding taking on insurance risks. hedged alternative investments that exhibit low correlations to Dispersion in credit markets coupled with the need for yield broader risk assets. should also provide a good opportunity for long/short credit managers and dispersion trading as many industries and The above reflects the opinions of the K2 Investment & Research Management (IRM) group as of December 20, 2020, and may not reflect the views of other groups within K2 or Franklin Templeton. The information provided is not a complete analysis of every material fact regarding any country, market, industry, security or fund. Because market and economic conditions are subject to change, comments, opinions and analyses are rendered as of the date of this material and may change without notice. A portfolio manager’s assessment of a particular security, investment or strategy is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy; it is intended only to provide insight into the fund’s portfolio selection process. For Institutional/Professional Investor and Consultant Use Only—Not for Use with Retail Investors. Hedge Fund Strategy Outlook—Q1 2021 3 Q1 2021 Outlook: Strategy Highlights Long/Short Equity—International More importantly, EM countries are in a strong fundamental Given the impressive recovery of US equities since the first position given the creation of long-term wealth through a quarter, we believe that international long/short strategies are rising middle class and more recently, less reliance on fiscal poised to outperform. European and Asian markets have support during the pandemic. generally traded
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