Macro Mojo:
Macro is Back
"The reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium, not equilibrium."
― George Soros
Macro is back and it’s time for prudent investors to start rotating investment dollars back into the strategy. But what does that mean; “macro?” The beauty and the curse of macro investing is that the definition is a bit amorphous. For managers, the ability to jump in and out of asset classes expands the opportunity set, but often at the expense of a deeper fundamental understanding. For allocators, it has the potential of providing very effective portfolio diversification, but also a potential inability to know when/how that diversification will work in the context of their broader portfolio. For the sake of simplicity, let’s define “macro” managers for this writing as managers who deal largely in interest rates and FX, making their money via country to country RV, curve trades, etc. and tend to construct portfolios that have a bias to being long volatility. Since the 2008 crisis, there have been innumerate “macro tourists.” Managers of all shapes and sizes started calling themselves “macro” or building the “top down approach” component of investing into their spiel. While that was understandable on the heels of the 08 crisis, most of those managers, especially equity long/short types, proved largely inept at understanding the macro drivers. By and large, their brethren, the “professional” macro managers, only faired moderately better (from 2008-2011 or so). Many of the reasons for that sub-par performance are to be indirectly highlighted below. In short, they are the reverse of why now is a great time for allocating to a macro manager:
1) Hedge funds tend to do better during tightening cycles (relative to both their own performance during easing cycles and to passive strategies).
2) The regime of coordinated central bank policy that has existed since the fall of Lehman is ending and the divergence of policy will create opportunities particularly well suited for macro managers to capture.
3) The combination of the first two is likely to lead to greater economic uncertainty and increased volatility (as seen over the last two months). More policy changes will increase the likelihood of a policy mistake, which historically has created some of the most fertile opportunities for macro managers.
4) Macro provides nice diversification against other equity-centric strategies currently being heavily allocated to (understandably so) such as event driven and PE.
5) Macro as a “bucket” has performed poorly over the last couple years and fallen a bit out of favor among allocators. As such, managers are willing to cut better fee deals. Additionally, “macro tourists” have largely been exposed and culled during the challenging environment of the last two years leaving behind managers with robust strategies and sound risk management.
Hedge Funds and Cycles
“Hedge funds as a whole have historically underperformed broad equity markets in easing cycles and have historically outperformed both equities and fixed income in tightening cycles. The principal driver of this thesis is that during easing periods, the central bank is encouraging risk taking and the ‘hedge’ component of a hedge fund becomes a meaningful drag on performance. As monetary stimulation is taken away, risk between securities becomes more relevant and the ‘hedge’ component becomes more valuable as dispersion of asset returns increases.” The above quote and below graph come from an excellent paper written by Christopher Paolino and Phillip Titolo at HIMCO. They also point out that the tailwind created by excess liquidity during easing cycles tends to be lost during tightening cycles. The lack of that tailwind allows for more dispersion among assets, especially equities, and therefore is more rewarding of fundamental analysis. While that may suggest allocating to areas other than macro, it’s worth pointing out that macro, as part of a larger portfolio, still has provided better returns on both an outright and risk adjusted basis, than a long-only bond portfolio during those tightening cycles (a further breakdown by HF strategy can also be seen in the above-mentioned and below paper).
http://www.himco.com/sites/himco/files/1287788311140.pdf, Christopher Paolino and Phillip Titolo, May 2014
Policy Divergence
After the near failure of the entire banking system in 2008, central banks (CBs) globally engaged in an unprecedented experiment – coordinated easing. While the Fed would likely argue they cared little about what the ECB was doing and vice versa, the actions of most of the major CBs on the planet are well documented. The ECB was uniquely stubborn which contributed to both turmoil and opportunity in the region, specifically in 2011 and 2012. Markets and data, however, eventually forced their hand. The result, especially since 2013 has been rates curves across countries/regions that look more or less identical. Their conformity is even more staggering in real terms and the real rates are negative. This has largely eliminated much of the country to country relative value opportunity set for macro managers and also contributed to volatility levels at or near all-time lows in both rates and FX pairs.
Inflation-Indexed Government Bond Yields
Source: http://www.federalreserve.gov/newsevents/speech/bernanke20130301a.htm
and Bloomberg
As we sit here today, that policy coordination is ebbing as global systemic risks have waned and more nationalistic interests have pushed to the fore. Some of the G10 are already starting to, or at least contemplating, tightening while others are still fully entrenched in their easing cycles. In the US, unemployment continues to come down and inflation concerns are becoming more near term. The Fed has announced the end of its QE buying program last May and while equity markets seem to have a 20% hiccup every time a round of the Fed buying program ends (which may be the culprit for the last couple months as well), it’s clear the Fed is on its way to tighter policy with timing and speed still to be determined. Similar paths are being taken by Australia and the Bank of England. On the other side of the coin, the ECB finally found religion and began an actual easing program. The Bank of Japan, under Abenomics, has clearly outlined its goals for easing. In Brazil, they are also tightening, albeit for different reasons as they attempt to guard against runaway inflation. All of the above provide the backdrop for an investing landscape particularly well suited for those that can capture inefficiencies in rate curves and FX.
Volatility
If one purpose of easing cycles is to create a tailwind for investment in risk assets (in order to stimulate growth) by mitigating risk, hence reducing some of the uncertainty of investment, then it stands to reason that the lack of that risk mitigation in a tightening cycle will necessarily lead to increased uncertainty. Increased uncertainty is then likely to lead to increased volatility. When there’s little volatility in a market, managers talk incessantly about how much they need volatility in the market to make their returns. In reality, they tend to want volatility the way they want it and sometimes it shows up in less friendly ways. In general though, macro managers tend to carry a long volatility profile, either via the use of options, the generally negatively correlated component of their rates books, or just because that’s what they’ve communicated to their investors so they could attract capital. In any case, years like 2008 were actually pretty good for a lot of macro funds and funds that saw the ball well in 2011 also prospered. The best analogy is that of a surfer: you can’t surf on a lake with no waves, and most of us are not towing into Mavericks. The best environments are those where there are consistent and somewhat manageable waves. Every now and then, there’s a big set and you start hearing people scream “outside!” It’s usually the macro guys most prepared for those rogue sets (if this reference is a bit obscure, I highly suggest watching either The Billabong Odyssey or Step into Liquid).
A second point on the likely expansion of volatility is less fundamental, and more mathematical. Without getting into crazy math, the simple explanation is as follows. A “moment” in statistics is a quantitative measure used to describe the shape of a set of points. When applied to probabilities, the first moment is the total probability, the second is the mean, the third is the variance, and the forth is the skewness. Volatility in markets, while not exactly the same as variance, is very close in both concept and calculation. This is important when incorporated in the following mathematical truism; the higher the moment, the more mean reverting it is likely to be. Said differently, skewness is more predictable than variance, which is more predictable than the mean, etc. Given that we are coming off a summer where many FX pairs saw all-time lows in volatility, one might then conclude that increased volatility, a reversion toward the mean, is likely over the next few months/years.
It’s also worth noting that positive skew in manager performance is often evidence of a long volatility strategy. As such, many good macro managers will demonstrate a large positive skew. Almost every other HF strategy has negative skew and imbedded beta. This leads to the next point.
Macro as a Diversifier
The result of the quantitative easing process has been to push investors out the risk curve by way of eliminating positive remuneration of safer assets. In many ways, this was the point. Hard to own treasuries because there’s little yield, that then pushed into the structured credit market, then high yield and by 2013 public equities finally capitulated as well. Now, the opportunity set is largely in less liquid deals, venture, et al. While there is still some very interesting things out there in the less liquid space (see previous thought pieces from July and August: http://www.stormontcap.com/#/writings), investors recognize that a grab for yield cannot last forever. Eventually the yield grab will involve inappropriate risks for not enough return and the cycle will crest. As part of a barbell type approach, macro HFs fit very well into a portfolio juxtaposed against some of these less liquid opportunities. Macro is highly liquid and tends to carry a correlation profile (generally speaking) more like that of a bond portfolio, although with a better Sharpe and outright returns than bonds during tightening cycles, according to Paolino and Titolo Allocators sometimes shy away from macro because they get a tail wagging the dog effect in their portfolio – the diversifier dominates returns. A macro manager with a consistent approach and good risk management should not cause this problem. With the right manager, you also get what I call negative gamma. Gamma is the rate of change in a securities price. So, in months when equity portfolios are gapping down, you want other investments that are gapping up. So, rather than an investment that’s negatively correlated over time on average, an investor (especially one that has underlying investors they need to report to) wants investments that are going to be very negatively correlated when it matters most. A good macro manager can do that.
Buy While Cheap
To the delight of investors and chagrin of HF managers, the days of opening your fund and getting all of your investors to pay 2/20 are coming to an end. Clearly the David Tepper’s of the world can still charge that, but even some of the staple equity shops like Viking and Lone Pine have created 40 act or long-only vehicles with cheaper fee structures. Good macro managers, of which there aren’t that many, still have a good theoretical argument for higher fees as very little that they do can/should be attributed to beta. That theoretical argument has fallen on deaf ears though over the past few years as performance hasn’t merited even an investment, much less fees. As such, there are many managers (even very good ones) who are willing to cut deals in order to grow assets and build their businesses. As mentioned above, many of the “macro tourists” have been exposed over the last few years and their businesses are no longer. The remaining managers in many cases are those that have maintained both discipline in their process and robust risk management. As such, their willingness to cut deals is not likely to last forever as the tide will (this writing argues it has already begun to) turn. When it fully turns and macro becomes en vogue again, those fee deals will be gone.
Macro is not a sexy strategy among allocators right now and readers may thumb their nose at the idea of macro allocations as we sit here today. However, with all of the above as a backdrop, it seems like that attitude might be worth revising. I may be early, but I’m calling it – Macro is back!
