k2 hedge fund strategy outlook · hedge fund strategy outlook—q3 2020 for...

K2 HEDGE FUNDSTRATEGY OUTLOOK

Q3 2020

Hedge Fund Strategy Outlook—Q3 2020

For Institutional/Professional Investor and Consultant Use Only—Not for Use with Retail Investors.2

Q3 2020 Outlook: Summary

Discretionary Macro

Managers may be presented with attractive macroeconomic dispersion opportunities driven by differences in how countries are affected by and responding to the ongoing health and economic crises.

Long/Short Equity Generalist

COVID-19 has resulted in equity sector and intra-sector dispersion, while simultaneously accelerating the timeline of expected favorable and fading long-term trends. However, investors remain uncertain of how the economic recovery will unfold.

Long/Short Credit

Back from the brink, managers can refocus on fundamentals, and economic reopening will create winners and losers. Managers can also deploy relative value and capital structure arbitrage trades, isolating risk at the issuer and the security levels, respectively.

In our view, we continue to believe pricing dislocations between companies, industries, regions and asset classes due to the impact of COVID-19 and corresponding price adjustments offer abundant opportunities for select hedged strategies. The length and depth of both the economic and supply-and-demand curve adjustments are key to the richness and tenor of the opportunities.

Strategy Highlights

Long/Short Equity While the shutdown provided an outline of sustainable winners and losers in a post-pandemic world, we believe the wide divergence in how companies will navigate the global economic shutdown and its gradual reopening presents abundant investment opportunities in equity markets.

Relative Value Volatility and dispersion remain elevated, offering attractive potential opportunities for relative value and trading-oriented strategies across equity and convertible bonds markets. We expect volatility in interest rates to remain depressed for now.

Event Driven Merger arbitrage spreads have come down meaningfully, though they remain wider than pre-crisis levels. We expect there to be less corporate activity in traditional merger arbitrage, but possibly more activity in special situations equity and credit investing.

Credit An uneven economic reopening can create winners and losers, offering opportunities for long/short credit managers. Structured products are off the March lows but have only recouped a fraction of the drawdown, which could make for an attractive entry point.

Global Macro The extraordinary health and economic crises of recent months have been followed by similarly extraordinary policy responses. Attractive opportunities may materialize for nimble managers around these responses and their relative effectiveness, particularly in the context of diverse macroeconomic starting points for the countries involved.

Commodities Time and geographical arbitrage opportunities are improving in metals and energy markets due to the variability of COVID-19 demand recovery across regions and less competition in the space.

Insurance-Linked Securities (ILS)

Pricing was attractive across all ILS natural catastrophe risk tiers during the June renewal period, in our view. Lack of available capacity in retro and private reinsurance has contributed to higher pricing. We believe catastrophe bond spreads remain attractive on an absolute basis and relative to corporate high-yield benchmarks.

This presentation 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 presentation 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.

Strategy Outlook



COVID-19: Will there be a second wave pandemic, or will economies reopen successfully?As economies reopen and the rate of COVID-19 case growth slows, the logical next question is “will there be a second wave of infections?” While impossible to predict, the recent social distancing efforts may well last until a safe vaccine is found and/or the virus is otherwise eradicated. Companies involved with cashless payments, online product and service offerings, in-home entertainment, and other non-contact services may recover from the recent economic lockdown more quickly than traditional retail business models.

Will the recent growth in telecommuting continue post-COVID-19?The pandemic forced millions of workers to work from home (or worse, lose their job). In addition, the fear of infection while attending public events may persist well beyond governments’ relaxing of social distancing rules and guidance. Many economists and strategists believe this will lead to a long-lasting cultural shift that will have a positive impact on some areas of an economy while enhancing business and government stresses in other areas.

Examples of companies that should benefit include:

• Those offering hardware and software that enhances home-based technology infrastructure

• Home maintenance and renovation retailers• Food and package delivery services• Online retailers

Conversely, areas that may see ongoing demand destruction include:

• Airlines and mass transit• Commercial real estate• On-site entertainment facilities (theaters, restaurants, casinos,

sports and concert arenas, etc.)

Companies and cultures able to maintain growth while reducing expenses may see their equity and fixed income investments outperform those still reliant on traditional on-premises work environments.

What market and economic impacts may arise due to the recent fiscal and monetary stimulus?It is well-known that central banks around the world have offered much support through interest-rate cuts and quantitative easing. With many economies reopening, we have begun to see a stabilization in many growth indicators as the liquidity flows through the system. Should the health crisis continue to diminish alongside the return of consumer spending or the implementation of government infrastructure projects, there is a possibility that inflation comes in above the current low expectations. Additionally, some of our managers are talking about the potential for the US dollar to weaken. This would be a potential tailwind for global commodity prices to move higher.

In this environment, one might expect the US yield curve to steepen, non-US equities to outperform domestic equities, and the dispersion of credit instrument returns to widen. Such a scenario would likely benefit long/short equity, macro/CTA, and long/short credit managers.

How might the upcoming US election and ongoing civil protests globally affect markets?While equity and bond volatility will most likely not reach the levels seen in March, we believe the geopolitical uncertainties and slow economic recovery cycle will cause volatility to remain above average. Protests in Europe, Hong Kong and now the United States are indications of the frustrations felt by populations around the world. Laws and policies are being adjusted, moral codes are being re-written and inequities are being challenged. The unhappiness of the populace alongside the strains of the health and economic crises may persist for a while.

Specific to the United States, President Donald Trump’s recent policy decisions have caused his approval rating to drop. Some polls suggest that Democratic presidential candidate Joe Biden is leading in the race for the White House this November. While the market impact of a Biden victory is difficult to determine, the uncertainty between now and the election may well contribute to market volatility.

The above reflects the opinions of the K2 Investment & Research Management (IRM) group as of June 22, 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.

Macro Themes We Are Discussing


For Institutional/Professional Investor and Consultant Use Only—Not for Use with Retail Investors.

Will the geopolitical initiative from various countries to deglobalize prove sustainable?Given the recent trade battles (United States/China) and economic bloc restructurings (Brexit), there seems to be a move by various countries to enhance their sovereign self-reliance. Government and business leaders speak of bringing production facilities and supply chains back from offshore locations to support local employment and avoid cross-border tariffs.

This would entail a sizable shift in corporate capital expenditure plans and foreign exchange flows among the major economies of the world.

This shift in thinking may lead investors to rotate their investment flows away from those sectors that historically have benefited from lower-cost offshore labor or production facilities. Instead, the marginal investment assets may tilt toward companies and credits that are currently profitable in their local domicile.

The above reflects the opinions of the K2 Investment & Research Management (IRM) group as of June 22, 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.

Macro Themes We Are Discussing



Source: Goldman Sachs Global Coronavirus Policy. Important data provide notices and terms available at www.franklintempletondatasources.com.

Discretionary MacroThe extraordinary policy measures taken so far to combat the health and economic crises related to COVID-19 may create attractive opportunities for nimble managers focused on macroeconomic developments. We think relative value opportunities may present themselves in macro asset classes like currencies, which can be driven by disparate policies and wide dispersion in economic conditions between countries before and after the policy implementation.

Q3 2020 Outlook: Strategy Highlights

Long/Short Equity GeneralistCOVID-19 has resulted in economic uncertainty, and comingout of the crisis, we do not anticipate a “one-size-fits-all” recovery. We expect share price dispersion across and within sectors while simultaneously accelerating the timeline of positive and negative long-term trends. Managers should be able to exploit the considerable uncertainty around the shape of the economic recovery.

Fiscal Easing Response to Health and Economic CrisesJanuary 1, 2020–June 15, 2020% of gross domestic product (GDP)

2021 US GDP Growth Rate ForecastsAs of June 17, 2020

Source: Bloomberg. Important data provide notices and terms available at www.franklintempletondatasources.com. There is no assurance that any estimate, forecast or projection will be realized.

6.7%

8.6%

3.9%

12.6%

3.6%

6.0% 5.5% 5.5%

2.3% 2.7% 3.1%

0%

2%

4%

6%

8%

10%

12%

14%

World DM EM USA Euro Area(Big Four)

Japan Other DM China** Asia Ex. China Ex. Japan

CEEMEA Latam

Region Developed Markets (DM) Emerging Markets (EM)

%

-4

-2

0

2

4

6

8

10

12

14

Feb-19 Mar-19 Apr-19 May-19 Jun-19 Jul-19 Aug-19 Sep-19 Oct-19 Nov-19 Dec-19 Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20

2021 Consensus GDP forecast High forecast Low forecast 2021 Fed SEP Median



Long/Short CreditWith credit markets gripped by extreme levels of volatility in March, new issuance in high yield froze. In response to the crisis, the US Federal Reserve introduced a number of emergency measures that effectively thawed key markets. Since then, the primary market has been extremely active, with issuers eagerly returning to capital markets. This level of activity can create opportunities for long/short credit managers in two respects.

Q3 2020 Outlook: Strategy Highlights

First, managers can buy bonds directly from the company and sell them into the secondary market, often at a premium. Second, a flurry of activity often means the market is less discerning at the individual deal level. Managers can apply a relative value approach, initiating a long position in one company against a short position in another company in the same industry, effectively isolating risk in the trade to the individual issuer.

Weekly High-Yield Bond Issuance YTDJanuary 2, 2020–June 11, 2020US$ billion

0

5

10

15

20

25

1/2/

20

1/9/

20

1/16

/20

1/23

/20

1/30

/20

2/6/

20

2/13

/20

2/20

/20

2/27

/20

3/5/

20

3/12

/20

3/19

/20

3/26

/20

4/2/

20

4/9/

20

4/16

/20

4/23

/20

4/30

/20

5/7/

20

5/14

/20

5/21

/20

5/28

/20

6/4/

20

6/11

/20

Source: J.P. Morgan. Important data provide notices and terms available at www.franklintempletondatasources.com.



Q3 2020 Outlook by Strategy

Long/Short Equity

The COVID-19 pandemic has reinforced the importance of long/short equity investing. The unprecedented global lockdown and gradual reopening of economies have resulted in a heterogenous response to the recovery. Long/short equity managers have been identifying companies whose extreme stock moves have been propagated by the panic, and their investment theses were somewhat clarified in the most recent earnings season. Yet many companies remain wary of providing quarterly and fiscal-year guidance in 2020. This should lead to a wider range of bottom-up estimates and outcomes and a pickup in market volatility and dispersion. Managers maintain higher gross and moderate net exposures, reiterating their conviction in their long and short books in an opaque market environment.

Relative Value While volatility has subsided from recent historic peaks, it remains significantly elevated, reflecting the continued uncertainty associated with COVID-19 and the market reaction to it. This environment should continue to present attractive trading opportunities for relative value strategies, particularly as dispersion picks up. One of the strategies where this is observable is convertible arbitrage, where the recent record levels of new issuance have helped to significantly diversify and grow the market, even as the universe of managers competing in the space has shrunk to a handful of experienced participants. Longer term, we believe that the continued provision of liquidity by central banks will eventually lead to greater imbalances in the traditional fixed income and rates markets. In the near term, however, we expect rate volatility (and interest rates themselves) to remain depressed, somewhat limiting opportunities for trading.

Event Driven As merger arbitrage spreads have tightened from the recent record levels, managers in the strategy were able to capture much of the recovery from that normalization. Going forward, we expect deal volumes to be lower than in prior years, somewhat constraining the opportunity set. In the longer term, both defensive and opportunistic mergers will likely continue, and companies may need to get creative with their capital structures, leading to some opportunities in special situations equity and credit strategies. But for now, we expect the supply of opportunities to be less than the availability of capital waiting to be deployed in the space, leading to our underweight positioning.

Arrows represent any change since the last quarter-end.



Q3 2020 Outlook by Strategy

Credit The extreme volatility experienced in credit markets in March has given way to a stabilization and partial recovery through mid-June. With the downside tail scenario for COVID-19 seemingly off the table and with key markets backstopped by emergency measures from governments and central banks, many investors are now turning toward the reopening of global economies and the associated impact on credit markets. In long/short credit, managers may be able to generate alpha by identifying the issuers that have sufficient liquidity to weather the potentially lengthy and uneven reopening process. Structured credit is off the March lows, but the sector has generally only recouped a fraction of the losses, making for what we believe to be an attractive entry point. Furthermore, the recovery has not been uniform. Managers willing to engage in detailed underwriting in unloved areas of the market could find value. The outlook for distressed investing has improved on the margin, given the expected increase in activity, but the opportunity remains more theoretical than realized for now, given the significant amount of capital on the sidelines waiting to be deployed. Direct lending managers will likely face higher defaults, so having workout experience and asset management capabilities will be key.

Global Macro Macro policy reactions to the health and economic crises may create attractive opportunities for forward-looking discretionary managers, particularly those who can nimbly navigate uncertain markets and higher volatility. The relative value opportunity set appears attractive, as we expect winners and losers to emerge from this environment. Given the high degree of uncertainty and a potential disconnect between asset prices and economic fundamentals, we have slightly less conviction in some directional approaches but acknowledge dislocations can prove attractive entry points for specialists like those focused on emerging markets. We maintain our neutral view on systematic strategies that can get caught in choppy volatility or perform well if key market factors prove sustainable.

Commodities Given our relative value focus within the commodities strategy, we expect to see an increasing opportunity set as demand recovery varies across geographies, leading to higher regional price dispersion. In addition, as banks have pulled back on their involvement in commodity markets, we continue to see wider arbitrage opportunities in energy and metals. We expect larger agriculture markets like grains and oilseeds to remain challenged, with sufficient supply resulting in subdued volatility levels absent key weather events or a significant trade deal.

Insurance-LinkedSecurities

As we enter hurricane season, the third quarter is generally the highest accrued income quarter for the ILS market. The catastrophe (cat) bond market spread remains wide and is near its early 2013 highs. The cat bond market size declined as maturing bonds outpaced new issuance. The June 1 Florida reinsurance renewals experienced overall risk-adjusted rate increases of 15%-20% on average versus last year on less available risk capital. There was an increase in hedging demand ahead of the upcoming hurricane season, leading to significant price increases in the industry loss warranties (ILW) market. Following the COVID-19 outbreak, investors have become more stringent on terms and conditions to protect against virus-related exposure. The life securitization sector has faced minimal losses so far from the coronavirus outbreak, which continues to develop. We remain more constructive on natural catastrophe over life risk from a pricing perspective.



> +1 Strongly Overweight+0.5 to +1 Overweight-0.5 to +0.5 Neutral-1 to -0.5 Underweight< -1 Strongly Underweight

Outlook Trend for Strategies and Sub-Strategies Sub-Strategies Ranked by Z-Score

Strategies Q2 2020 Q3 2020 Changes

Long/Short Equity —

Long/Short Equity —

Equity Market Neutral —

Activist —

Europe

Asia —

Technology —

Healthcare —

Relative Value

Convertible Arbitrage —

Volatility Arbitrage

Fixed Income

Event Driven

Merger Arbitrage

Special Situations —

Credit

Direct Lending —

Distressed

Long/Short Credit —

Structured Credit

Global Macro

Discretionary —

Systematic —

Emerging Markets —

Commodities —

Oil & Products —

Agriculture —

Metals

US Natural Gas —

Insurance-Linked Securities —

Catastrophe Bonds

Private Transactions —

Life Securitization —

Retrocessional

Industry Loss Warranties

The K2 Investment Research & Management (IRM) Outlook Scores are the opinions of the K2 IRM group as of the date indicated and may not reflect the views of other groups within K2 or Franklin Templeton. Scores are determined relative to other hedge fund strategies and do not represent an opinion regarding absolute expected future performance or risk of any strategy or substrategy. Scores are determined by the K2 IRM group based on a variety of factors deemed relevant to the analyst(s) covering the strategy or substrategy and may change from time to time in K2’s sole discretion. In certain sections of this presentation, outlook scores are rounded to the nearest whole number. These scores are only one of several factors that K2 uses in making investment recommendations, which may vary based on a client’s specific investment objectives, risk tolerance and other considerations. Therefore, underweightings and overweightings as shown are meant to indicate K2's view of relative attractiveness of hedge strategies and are not meant to indicate that a particular strategy or sub-strategy should be overweighted or underweighted, respectively, in any given portfolio. This information contains a general discussion of certain strategies pursued by underlying hedge strategies, which may be allocated across several K2 strategies. This discussion is not meant to represent a discussion of the overall performance of any K2 strategy. Specific performance information relating to K2 strategies is available from K2.

Rankings (Top Down) Z-Score

Discretionary 1.5

Retrocessional 1.4

Emerging Markets 1.4

Catastrophe Bonds 1.0

Europe 0.9

Volatility Arbitrage 0.8

ILWs 0.7

Metals 0.4

Asia 0.4

Long/Short Credit 0.3

Long/Short Equity 0.3

Technology 0.3

Private Transactions 0.2

Activist 0.2

Convertible Arbitrage 0.2

Health Care 0.2

Systematic 0.1

Equity Market Neutral 0.1

Structured Credit -0.3

US Natural Gas -0.3

Oil & Products -0.4

Distressed -0.4

Merger Arbitrage -0.6

Agriculture -0.7

Direct Lending -1.3

Fixed Income -1.6

Special Situations -1.8

Life Securitization -2.8



GlossaryAlphaA mathematical value indicating an investment's excess return relative to a benchmark. Measures a manager's value added relative to a passive strategy, independent of the market movement.

CorrelationThe degree of interaction between an investment’s return and that of the comparison Index. The correlation coefficient, expressed as a value between +1 and –1, indicates the strength and direction of the linear relationship between the investment’s returns and the returns of the index.

RetrocessionalA type of insurance contract that allows a re-insurer to transfer risks it has re-insured to another re-insurer.

Z-scoreA Z-score is a numerical measurement used in statistics of a value’s relationship to the mean (average) of a group of values, measured in terms of standard deviations from the mean. If a Z-score is 0, it indicates that the data point's score is identical to the mean score.



DISCLOSUREThe K2 Investment Research & Management (IRM) Outlook Scores are the opinions of the K2 IRM group as of the date indicated and may not reflect the views of other groups within K2 or Franklin Templeton. Scores are determined relative to other hedge fundstrategies and do not represent an opinion regarding absolute expected future performance or risk of any strategy or substrategy. Scores are determined by the K2 IRM group based on a variety of factors deemed relevant to the analyst(s) covering the strategy or substrategy and may change from time to time in K2's sole discretion. These scores are only one of several factors that K2 uses in making investment recommendations, which may vary based on a client's specific investment objectives, risk tolerance and other considerations. Therefore, a positive or negative score may not indicate that a particular strategy or substrategy should be overweighted or underweighted, respectively, in any given portfolio.This information contains a general discussion of certain strategies pursued by underlying hedge strategies, which may be allocated across several K2 strategies. This document is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or invitation to apply for shares of any of the funds employing K2 strategies. Nothing in this document should be construed as investment advice. Specific performance information relating to K2 strategies is available from K2. This presentation should not be reproduced without the written consent of K2.Past performance is not an indicator or guarantee of future results.Certain information contained in this document represents or is based upon forward-looking statements or information, including descriptions of anticipated market changes and expectations of future activity. K2 believes that such statements and information are based upon reasonable estimates and assumptions. However, forward-looking statements and information are inherently uncertain and actual events or results may differ from those projected. Therefore, too much reliance should not be placed on such forward-looking statements and information.Professional care and diligence have been exercised in the collection of information in this document. However, data from third party sources may have been used in its preparation and Franklin Templeton/K2 has not independently verified, validated or audited such data.Any research and analysis contained in this document has been procured by Franklin Templeton/K2 Investments for its own purposesand is provided to you only incidentally. Franklin Templeton/K2 shall not be liable to any user of this document or to any other person or entity for the inaccuracy of information or any errors or omissions in its contents, regardless of the cause of such inaccuracy, error or omission.

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For Institutional/Professional Investor and Consultant Use Only—Not for Use with Retail Investors.

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This material is intended to be of general interest only and should not be construed as individual investment advice or a recom-mendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at July 1, 2020 and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.All investments involve risks, including possible loss of principal.Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.The information in this document is provided by K2 Advisors. K2 Advisors is a wholly owned subsidiary of K2 Advisors Holdings, LLC, which is a majority-owned subsidiary of Franklin Templeton Institutional, LLC, which, in turn, is a wholly owned subsidiary of Franklin Resources, Inc. (NYSE: BEN). K2 operates as an investment group of Franklin Templeton Alternative Strategies, a division of Franklin Resources, Inc., a global investment management organization operating as Franklin Templeton.Issued in the U.S. by Franklin Templeton, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com—Investments are not FDIC insured; may lose value; and are not bank guaranteed.

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