Investing In Hedge Funds: About turn for top-down
The last few years have not been a good time to be in macro hedge funds. Their performance has been disappointing during a period when equity markets have soared. Not surprisingly perhaps, Hedge Fund Research (HFR) figures show that investors pulled out a net $10bn from macro funds in the first half of 2014, which followed four calendar years of negative returns to the HFRX Macro/CTA index.
“We continue to run no exposure to macro and that has been the case for the last couple of years,” says Ray Nolte, CIO of fund of funds firm SkyBridge Capital. “In the past, we have had as much as 35% in macro, but the problem at the moment is that there is very little predictability in the return streams that managers generate and we have very little confidence in their performance in any particular month. The consistency and predictability of macro returns in the context of a broader portfolio has been very challenged during the last couple of years.”
Despite this gloomy analysis, there are signs that macro strategies may be heading for a comeback – year-to-date returns to HFRX Macro/CTA were at 2.6% at the end of October 2014, compared with 1.2% for the broad hedge fund universe – and opinions of other hedge fund investors are much more positive. But are they just imagining the green shoots of spring for a set of strategies still stuck in the depth of winter?
The reasons for the poor performance and lack of predictable returns for macro and CTA strategies after their terrific showing during the financial crisis are centred round the unconventional monetary policy engineered in response to that crisis.
This manipulation of markets has seen financial assets appreciate substantially against a background of poor global macroeconomic fundamentals. When markets react violently to policy decisions by central banks rather than changing economic fundamentals, macro hedge fund strategies struggle to decide whether to align themselves with, or against, those policies.
“Central bank interventions have caused sudden reversals of trends which has made it a tough environment for all CTAs,” says Fabrice Cuchet, CIO for alternative investments at Candriam.
More generally, central bank actions have resulted in low interest rates, reduced volatility and high correlations, all of which have contributed to poor performance by macro hedge funds.
At a glance
• Macro and CTAs had a few years of poor returns driven by the unconventional monetary policy undertaken by central banks.
• Low rates have hit margin-trading strategies, policy-driven markets have been tricky for top-down fundamentals-based strategies to navigate, and sharp policy-driven market reversals have whipsawed trend-followers.
• Divergent policies and increased volatility gives hope that macro could start performing again, just as equities look stretched and credit spreads tight.
• But there is still a decision to be made about which type of strategy best suits the current, transitional environment – or whether it is simply too early to take a position at all.
Low interest rates in themselves put a dampener on macro returns. As Sam Diedrich, head of macro strategies at PAAMCO points out, macro funds typically trade on margin, leaving them holding sizeable unencumbered cash – upwards of 80% of NAV is not unusual – which earns spread over short-term interest rates. The return stream of a macro strategy can therefore be described as Libor less fees, plus trading alpha. With interest rates near zero managers were essentially facing losses (Libor at zero, less non-zero fees) before they even started trading.
Low interest rates have also dampened risk premia. “As a result, the rewards for capturing these premia have also naturally declined,” says Diedrich. “The carry differentials between global currencies, for example, have been extremely tight in recent years despite the volatility of carry trades remaining very high.”
The abnormally low volatility in financial markets in recent years has been a crippling factor for macro strategies.
“The bread and butter trades for macro managers, by and large, are in currency markets, especially the larger ones, and also in rates,” explains Omar Kodmani, CEO of Permal Group, a fund of funds group with a preference for macro strategies. “When you have an extended period when all the major central banks in the world are running essentially a zero interest rate policy currencies are trading in very tight ranges and you don’t get many break-outs.”
Thomas Weber, managing partner at LGT Capital Partners, which provides a range of funds of funds that includes one focused on managed futures, concurs. “During the last few years, any risk averse behaviour has been very short-lived and volatility has been low which made it a difficult environment for discretionary and systematic managers to exploit,” he says. “On the other hand, the need for diversification by macro strategies was less needed in this positive market environment.”
Diedrich points out that during the period 1992-2007, the BarclayHedge Barclay CTA index had a Sharpe ratio of 0.24 during what was seen as a normal volatility regime, while the S&P 500 index had a Sharpe ratio of 0.49. In contrast, from August 2007 to September 2009, the CTA index had a Sharpe ratio of 1.61 and the S&P had a Sharpe ratio of -1.02. But since then, with the decline in volatility, the CTA index Sharpe ratio has been 0.01 while the S&P Sharpe ratio has been 1.38.
“That just illustrates how global volatility is such an important factor for macro strategies,” he says.
Macro strategies control risk through diversifying across a range of financial markets. But this has broken down because the focus on central bank policies has also led to ‘risk-on/risk-off’ behaviour and high correlations. Diedrich argues that this has made macro funds fearful about deploying risk, which has dampened returns.
Trend followers have also suffered not only because of the violent reversals of strong trends but also because the high correlations across asset classes has meant that there has been a dearth of diversity in trend opportunities.
“Despite diversifying across numerous asset classes and instruments, trend-following investors ultimately found that they were following varying paths to the same exposure to the ‘risk-on/risk-off’ trend,” says Diedrich.
However, fund allocators such as Kodmani, Diedrich and Weber see a more positive outlook, which Weber describes as a return to a more normal environment of increased volatility, lower cross-correlations and more divergence of central bank policy, economic cycles and market movements.
September was a good example of that environment, when systematic and discretionary macro managers generated positive performance in a month of declining equity and bond markets. PAAMCO even went so far as to invest in a dedicated multi-manager macro and relative value hedge fund in 2013, although Diedrich admits that, with hindsight, they were premature.
Nolte’s analysis of the recent performance of macro strategies is damning, but even he admits that once he sees evidence that global financial markets have moved away from the distortions caused by central bank policy actions, he would return to macro strategies.
The key to the more favourable environment for macro strategies is the better economic background in the US and UK compared to Europe and Japan. This is leading to a divergence of central bank policies as US and UK central banks signal an imminent tightening of policy as QE comes to an end at the same time as the ECB edges closer to QE and the Bank of Japan piles on more stimulus (surprising the market with a new round of printing at the end of October).
“Japan has no other strategy beyond the introduction of QE,” observes Kodmani. “In Europe, the ECB would like to introduce QE if it could overcome dissenting voices. More people are worried about deflation than inflation. As a result, currencies are moving in a dramatic way.”
What Kodmani sees as exciting from an asset allocator’s perspective is that macro is now kicking in and offsetting some of the sell-off that we see in certain risk assets.
“Macro is playing its desired role of being a diversifier and an outperformer during times of stress,” he says. “Volatility, which had been subdued by low interest rates, is making a comeback – you can see that in currency and bond markets, [where] macro traders [now] have much more scope.”
The increased volatility is evident in divergent behaviour within asset classes – between developed market equities and emerging market equities, for example, or within the emerging markets themselves.
However, deciding which types of macro strategies are best placed to exploit the increased volatility is not straightforward.
Macro can be divided into discretionary and systematic strategies. The industry is split around 60/40. Discretionary managers can be generalists covering multiple markets, specialists focusing on a specific asset class or region, or thematic traders. Systematic strategies cover both classic trend-following managed futures (CTAs) and also non-trend-following approaches based on algorithms that use data beyond pure price movements. What is common to them – as Diedrich points out – are low hit rates: macro strategies with a hit rate of 55% of bets turning out right are considered to be doing well, so managers need to ensure diversification across strategies.
“Macro managers typically have three to five theses and three to four expressions of each thesis, resulting in 10-20 bets on at any one time,” he says.
The success rate for systematic strategies is even lower so they rely on success by diversification across as many as 50-100 different bets at any one time, and fast action in cutting losing bets.
Alex Greyserman, chief scientist at ISAM and an evangelist for trend-following strategies who has co-authored Trend Following with Managed Futures: The Search for Crisis Alpha (Wiley, 2014), concedes that the Sharpe ratio of trend following in any single market will never be very high. For that reason, a successful programme requires diversification across a large number of time frames and market exposures in order to achieve both good risk-adjusted stand-alone returns and low correlation with traditional asset classes.
“It requires a significant effort,” he says. “For example, we have increased the number of markets we trade in by a factor of almost three from the number five years ago, covering new financial markets, alternative power, commodities, emissions, and so on.”
Diedrich argues in favour of maintaining diversification between different macro strategies at all times, whereas Kodmani argues for a tilt in exposures based on the macro and market environment.
“We have the view that we are in a world dominated by policy actions rather than economic fundamentals,” he says. “We are better off with managers who trade according to policy shifts rather than following systems that do not change.”
As a result, Permal has a heavy weighting of 90% of macro assets in discretionary strategies. Kodmani likes all approaches but prefers specialist and thematic managers as they give Permal the ability to take a role in determining appropriate exposures. “If we see an upside in Japan, it gives us the ability to allocate more to managers who are taking thematic bets in Japan,” he explains.
Candriam favours macro strategies that have a short (one week) to mid-term (two month) horizon. “We are not yet in a position to be able to bet on long-term trends,” says Cuchet.
Weber agrees. “The current market behaviour can be quite short term – a few days to a few weeks compared to medium- to long-term trends – so we have over-weighted short-term strategies.”
Longer-term price trends (greater than eight months) tend to pick up macro-economic effects which move slowly, whilst shorter-dated trend strategies can be a good risk management tool. In this transition period, going from a world dominated by central bank policy and investor sentiment to one in which macro fundamentals begin to take hold again, there may well be something to be said for this approach. Accessing a source of diversified returns uncorrelated with bond and equity markets is what makes both systematic and discretionary macro strategies attractive propositions. But for those returns to be positive and repeatable, the world needs to return to economic normality.
That is what holds back hedge fund allocators that have not made the move into macro strategies – whether discretionary or systematic, short-term or longer-term, or diversified.
“Our view is that we want to see real evidence that has occurred before we commit capital,” as Nolte puts it. “The evidence for that is still not there and till then, it is the luck of the draw with macro strategies.”
Investors must decide whether they agree with that assessment, or whether they believe that the performance of this October signal the odds moving back in global macro managers’ favour.