On an absolute basis, however, the return of the HFRI Macro Index this year has been unremarkable, at -1.9% through September. It is clear that the strategy has faced its own set of difficulties, despite a global environment that appears well-suited for macroeconomic investing. The opportunities offered by Europe’s problems, increased government participation in markets, and widely varying expectations for global growth and inflation have been embraced by most macro managers. The main headwinds to the strategy have been in the form of market whipsaws, difficult-to-forecast political developments and external shocks. While these headwinds may continue to persist, we believe that the broader environment will be conducive to the strategy over the medium-term.
Performance in times of stress
From a historical perspective, the stronger relative performance of macro during periods of market stress has been a defining characteristic of the strategy (see Fig.1). Global macro managers have shown the ability, through their flexible style, liquid portfolio holdings and top-down approach, to preserve capital through periods of deep and significant dislocations, thereby providing investors not only highly attractive standalone risk/return characteristics but also a strong portfolio diversification effect. During the credit crisis, the S&P 500 experienced a peak-to-trough drawdown of 51% while global macro strategies as proxied by the HFRI Macro Index returned +4.7%. When the tech bubble burst from September 2000 to September 2002, the S&P 500 fell 44.7%, but global macro strategies gained 15.5%.
For most strategies and asset classes, correlations to equity markets have tended to spike during crisis periods. The opposite holds for macro strategies: correlations to equity indices have declined during crises relative to the full period. In the credit crisis, the correlation between the HFRI Macro Index and the S&P 500 was -17%. In the three years preceding the credit crisis, the correlation was 49%. Over the past two decades, the correlation between the two indices has been about 35%. When only the months in which the S&P has delivered a negative return are considered, the correlation drops to 15%. The historical beta timing ability of macro strategies can be shown not only for exposure to traditional equity markets but to other forms of traditional and alternative risk premia.
Headwinds in 2011
To understand the weak absolute returns of macro managers this year, it is helpful to look back at the performance of generic trend-following models applied to major markets. While not all macro managers employ such strategies, strong directional moves form the basis of profitability for most macro strategies. Understanding how potentially rich in trends the environment is provides some intuition behind the performance of macro managers more generally.
This year, although there have been large moves in a number of asset classes, few have been readily exploitable. Markets that reached multi-day highs or lows during the year generally did not continue to move in the same direction over subsequent periods. A generic strategy that held long positions in markets that had exceeded their trailing 20-day high, and short positions markets that had fallen below their 20-day low would have lost money in virtually every major asset class this year. A similar result can be shown for other short-term and medium-term look back windows.
The only exceptions to the above pattern among major markets were in the precious metals and fixed income sectors, where trends unfolded in a smooth manner. The fixed income sector, however, presented managers with its own set of difficulties. Bond yields at multi-year lows and zero interest rate policies that put a lower bound on rates created what seemed to be an asymmetric opportunity set in fixed income. This led many managers to avoid the sector, or into loss-making short positions earlier in the year.
Many stock-pickers have pointed to the rise in single stock correlations and growth in ETF trading volumes as evidence that markets are moving on macro grounds, rather than on the basis of company fundamentals. High correlation levels have also impacted macro asset classes, reducing many investments to either a risk-seeking or risk-averse bet (see, for example, Fig.2 and Fig.3). Despite some clear macro forces apparently driving the market, the combination of large swings in investor sentiment and highly correlated markets have been adverse developments for most macro managers. It has been as much of a challenge for macro managers as for stock pickers to construct diversified portfolios with a sufficient number of independent bets. Not surprisingly, many macro managers opted to run smaller portfolios.
The heightened importance of government solutions in determining the direction of markets created additional hurdles for the macro strategy, as policy decisions tend to be difficult to forecast and are influenced by conflicting political objectives. However, as we argue below, the participation of governments in markets may have also strengthened the longer-term opportunity set for macro.
Outlook for macro
In speculative markets, it is difficult for profit-maximizing investors to earn excess returns as a group except through the activity of non-profit-motivated participants. Typically, hedgers and commercially-motivated investors have served this function, as they looked to transfer unwanted risks. Central banks have lately stepped into this role by entering financial markets directly to support their economies. In doing so, they may have created the opportunities for macro investors to trade in a non-zero sum environment. The renewed focus on finding structural solutions to fiscal problems may also have set the stage for a narrowing of potential outcomes in the growth and inflation trajectories of various economies, from which medium-term trends are more likely to emerge. An environment of slower growth should also be generally favorable for the strategy. In periods of economic weakness, fundamental issues gain in prominence and markets tend to be less forgiving of structural imbalances and unsustainable policies. These conditions can provide a fertile environment for macro investing. In contrast, a backdrop of strong, synchronized global growth tends to provide a degree of shock absorption to the global economy, diminishing the probability that disequibiriums will correct. Historical evidence also points to the weaker performance of the strategy in environments dominated by growth, as in the period from 2004 to 2006.
Investors face three major challenges in global macro investing: i) the inherently high volatility of the underlying macro managers; ii) the heterogeneity of the universe; and iii) the wide dispersion of returns within the strategy. These factors, which are typically further amplified in elevated volatility environments, expose investors to both adverse selection risk, through poor manager selection, and concentration risk via insufficient diversification across the range of global macro styles. We believe these factors strongly support the case for an actively managed and diversified portfolio of macro managers, where one is able to maximize efficiency across two main investment dimensions: skill and diversification.
According to Richard Grinold’s ‘Fundamental Law of Active Management’, alpha is a function of both the information coefficient, which is the manager and allocator’s skill in investment decision-making; and investment breadth, or the number of independent assets in the investment opportunity set. In other words, an improvement in risk-adjusted returns is generally dependent on an improvement in skill, typically achieved through the hiring, timing, and sizing of top performing managers; and diversification, through the construction of a portfolio with a broad mix of managers, and exploiting the low correlations across macro styles.
As markets become increasingly efficient, many macro managers have combated the inevitable degradation of alpha through the application of a more granular approach to investing with the ultimate goal of improving their directional forecasting abilities. Managers have sought this additional edge or skill via specialization by asset class (e.g., focus on currencies), predictive signal (e.g., exclusive focus on technical inputs) or time horizon (e.g., focus on intra-day opportunities). This movement towards specialization has resulted in a much broader and more heterogeneous set of macro managers than in the past. It has also offered the possibility for investors to achieve higher risk-adjusted returns through the optimal selection and sizing of managers.
Another approach to improving risk-adjusted returns with the same level of skill can be to diversify across uncorrelated strategies. Diversification is often said to be the only free lunch in finance. In the context of global macro, however, naïve portfolio construction often yields disappointing results. Macro sub-strategies that share common underlying return drivers, such as long-term trend following, tend to be highly correlated and to limit the portfolio benefits of allocating across several names. On the other hand, the correlations among managers utilizing distinct approaches, whether based on style, input type or time horizon, can be low or even negative, in some cases, and provide significant diversification potential.
Further complicating the diversification issue is that macro managers do not always adhere to a top-down directional investing style. In an attempt to reduce the volatility of their return streams, some managers have elected to move towards a multi-strategy approach involving both less liquid instruments and convergent relative value strategies. This type of style drift was particularly pronounced in the years prior to the 2008 financial crisis among large, discretionary managers. While these shifts may ultimately lead to more stable stand-alone returns for the managers, it can reduce the benefits to investors seeking diversification to traditional markets and other alternative strategies.
As such, we believe that investors should seek to gain exposure to global macro through a portfolio approach that maximizes diversity across various macro sub-strategies and managers, while retaining the strategy’s key benefit – its resilient risk/return profile through periods of market crisis and economic uncertainty.
Mark van der Zwan, CFA, is a portfolio manager for Morgan Stanley Alternative Investment Partners Fund of Hedge Funds. Radha Thillainatesan is an investment analyst for Morgan Stanley Alternative Investment Partners Fund of Hedge Funds.