In recent years, macro strategies have been criticised for delivering disappointing absolute returns. In 2017, one reason given for this was the lack of volatility in markets. So far in 2018 we have seen a resurgence of volatility, but apparently for many, it would seem to be of the ‘wrong type.’ I would argue that both these explanations for disappointing returns are incomplete, and that we should instead be looking to explain developments as reflections of a profound shift in the market environment and investor psychology. Understanding these shifts will be critical both for return generation, and risk management on a multi-year perspective, not just for macro managers, but for all investors.
In the middle of 2016, I wrote in this publication about my belief that investors would soon need a material change in thinking and behaviour (‘A Pivotal Moment’, June 2016). At that point, the combination of growth pessimism and a myopic desire to avoid short-term volatility had reached what will likely turn out to be their peak. Investment strategies which could avoid being correlated with drawdowns in ‘risky’ assets or, better still, offer protection in these periods were prioritised over those that might generate higher returns over the longer run.
Low volatility and ‘uncorrelated’ returns had become the holy grail for investors, and were the characteristics offered by many of the most popular macro strategies. Unfortunately, prevailing asset valuations and a changing regime meant that the assets and strategies which had delivered such outcomes in the past, looked likely to deliver disappointing, and possibly negative, returns in the future.
And so it proved. Since that point, we have seen a staggering shift in sentiment. This was due to the profound valuation misalignment that had opened up (between apparent ‘safety’ assets on one hand, and attractive, but volatile, assets on the other), and also to growth outcomes which surprised the deeply pessimistic forecasts implied by markets in 2016. Against this background we have seen some return of optimism and return-seeking behaviour, including the acknowledgement that the range of possible outcomes included ‘melt up’ as well as deflation. Ironically, the very fact that investors became more prepared to accept volatility, meant that markets themselves displayed far less volatility in 2017.
“Macro investing could well enjoy a renaissance…but to do so it will likely need to employ different approaches than prevailed in the old regime.”
Dave Fishwick and Stuart Canning Macro Investment Business, M&G Investments
Unsurprisingly, investment strategies which delivered low or negative returns in this environment were castigated for delivering just the type of low volatility and lack of correlation with risk assets that many had asked for only a year earlier (see ‘The Wrong Type of Macro,’ published in The Hedge Fund Journal in July 2017). One common response to these criticisms was that markets had ‘not been volatile enough’ to generate the type of alpha that these funds look for.
Volatility returned in 2018, but as a recent Bloomberg article pointed out, returns of many hedge funds still disappointed. At a recent investment conference, it was claimed that part of the reason for this was that it was the ‘wrong type’ of volatility.
Ultimately however, market dynamics in both 2017 and 2018 are a reflection of the same regime shift. This shift has meant that strategies that were successful for most of the post-crisis period have faced significant challenges. The ‘playbook’ from 2008 to 2016 was to seek short-term safety, and rate-sensitive assets were the tool to do this. Volatility was generally caused by growth fears, and when this happened, developed market government bonds (usually starting from a far more attractive yield than they had offered in 2016) would rally sharply. The strong returns in safety assets over this period meant that, contrary to financial theory, investors were typically rewarded, rather than penalised, for being volatility averse.
This was not the case when volatility returned in the first quarter of 2018. Instead, the environment demonstrated a further key element in the shift in regime that began with the ‘pivotal moment’ in 2016: we saw that ‘good’ news can cause volatility too.
The return of optimism and growth witnessed since mid-2016 has important consequences for global real interest rates and this, in turn, impacts the valuation of all assets. The most important chart for investors today is arguably the progression of the US two-year Treasury yield over the last twelve months (see Fig. 1).
US rates represent our best measure of the ‘risk free rate’ that underpins the valuation of all assets. In February 2018, it was the impact of ongoing rate increases against a background of firmer macro data that triggered volatility across all assets, not the growth fears that have been the cause of so many phases of turbulence since the financial crisis. In phases of ‘valuation shock’, both rate-sensitive and growth-sensitive assets can weaken as they are de-rated.
This correlating factor has important implications for macro strategies. The opportunity cost of seeking safety in those assets that had delivered insurance since the financial crisis was already evident (US ten-year Treasuries have delivered a negative return in real terms over the last five years), but now such assets can also represent a source of broader market volatility.
This means shifting correlation patterns across all assets, and a huge challenge to the existing portfolio construction and risk management mindset that has prevailed for much of the last decade. Q1 2018 represented the first quarter in the last twenty years where a fifteen-point increase in the inter-quarter high in the VIX index has not been accompanied by a positive return from US long-dated Treasuries (see Fig.2).
This is what commentators imply when they talk about the ‘wrong type of volatility’: the simple observation that this phase doesn’t resemble the patterns of the past. The confusion that this has caused can be seen in the various and changing narratives that have been used to explain or ex-post rationalise price action. The role of volatility products, trade wars, slightly softer macro data and, now, the impact of the technology sector are all relevant influences on asset prices in the short-term. But, they are all partial or incomplete explanations, and fail to acknowledge the profound change in the environment. It is this broader change that has created greater pricing model uncertainty in all assets. This uncertainty or ‘endogenous risk’ relates to the fact that nobody can be confident that they know the ‘right’ price or yield on any financial asset. As the ‘risk free rate’ rises, this can create asset price shifts and volatility that are not a function of ‘news’ as such; but merely changes in perception of risk and how investors believe they should be compensated for it.
Rising rates represent a huge threat, not just for government bonds, but for all assets that have been direct beneficiaries of the low-rate environment. Assets (and investment strategies) still priced for the previous regime could well continue to be challenged, as could strategies that rely on correlation patterns that prevailed prior to 2016.
Since diversification is not always available to the same extent and from the same sources, risk management needs to be dynamic and forward looking. A profound change in mindset may be required.
We could be entering a period in which diversification is best found in those assets that have not been sensitive to rates – largely those that were previously seen as the most risky. It may also include more aggressive use of shorting than has been required for much of the last decade. Perhaps most importantly, and in contrast to the Bloomberg article’s ‘wrong volatility’ perspective, success for macro strategies may not be about their ability to avoid short-term price declines, but rather their ability to profit from the opportunities that these create.
To do this, investors need a clear framework, but one that is flexible enough to succeed in different regimes, not just that of the post-crisis era. Targeting constant volatility levels, using stop-losses, and backward looking VaR models, could well act as a constraint on this flexibility.
I believe that price behaviour at the start of 2018 represents the ongoing evolution of a regime shift that began in 2016. This shift is ongoing and confusing, and is likely to be fraught with ‘relapses’ and periods of deep stress, with profound implications for all investors, and macro strategies in particular.
A move to higher real interest rates across the western world – one that is seen as sustainable –will have major consequences for asset returns and correlations. But, even if rates were only to stabilise or even decline, there has been a clear change in the asset-pricing environment to which all investors must adapt.
In the period after the financial crisis, shared market psychology incentivised managers to put capital preservation and asset correlation at the forefront of their proposition. Prioritising these elements resulted in the underperformance that many strategies have seen in recent years, while failing to observe that the environment has moved on has been the cause of much confusion so far in 2018. Macro investing could well enjoy a renaissance in the phase, but to do so it will likely need to employ different approaches than prevailed in the old regime.
 ‘Hedge Funds Finally Got Some Volatility. It Didn’t Help.’ Stephen Gandel, Bloomberg Gadfly, 13 March 2018. https://www.bloomberg.com/gadfly/articles/2018-03-13/hedge-funds-finally-got-some-volatility-it-didn-t-help