Post-financial crisis, investors have generally been dissatisfied with their investments in discretionary global macro hedge fund strategies.
- Backdrop for discretionary global macro investing has been improving
- Diversification into discretional macro strategies could mitigate market volatility risk to overall portfolios
Although performance in these strategies has not met investors’ expectations, the current backdrop for discretionary global macro investing has been improving. Monetary policy normalization is a key factor in the improving backdrop for the strategy, but high asset valuations also play into the strategies’ important role within a portfolio.
While it can be debated if equity-market valuations have reached so-called levels of “irrational exuberance,” most investors would agree that the future path of equities is less certain. This is good news for discretionary global macro investment managers, as any adverse moves, particularly in equities, would generally be accompanied by an increase in realized volatility. Historically speaking, discretionary global macro strategies have an inherent long volatility bias, and therefore can act as risk diversifiers in times of equity market stress.
Today, discretionary global macro managers remain focused on the path of monetary policy normalization by developed-market central banks. These managers are generally expressing this theme by implementing trades that will take advantage of the monetary policy normalization by global central banks, such as short positions in the interest rate markets of the U.S., Europe, and to a lesser extent, Japan.
Such an environment offers a compelling opportunity for macro strategies, but investors haven’t necessarily taken notice of these benefits yet.
Such an environment offers a compelling opportunity for macro strategies, but investors haven’t necessarily taken notice of these benefits yet. That’s because discretionary global macro managers have had challenges.
Their main challenge has been the combination of historically-low absolute levels of interest rates and central bank monetary policies aimed at suppressing volatility. When global central banks operate policy frameworks that are highly accommodative, with interest rates that are negative in real terms, it becomes more difficult for portfolio managers to rely on fundamental economic analysis that is used to derive thematic investment views and forecast asset prices.
Additionally, an environment where most risk assets are appreciating on a “rising tide” of central bank liquidity, macro strategies are naturally prone to underperform their more directional counterparts. What has happened is that the recent environment has rewarded passive long positions across the spectrum of risk assets, which is fundamentally at odds with how discretionary global macro portfolio managers manage their capital.
Discretionary global macro portfolio managers aim to generate returns that over time are uncorrelated to long-only equity and fixed income exposures, and are therefore disinclined to construct portfolios without substantial directional beta exposures. To take this point a step further, it may be beneficial to increase macro exposures when volatility is low and expected to rise, and decrease macro exposures when volatility is high and expected to fall.
If that hasn’t work for global macro strategies recently, what’s different now that could create a different outcome?
The expectation of global central banks exiting their highly accommodative post-financial crisis policies isn’t new, but the end of quantitative easing (QE) may bring other fundamental changes. Many discretionary global macro managers have been anticipating such a shift, resulting in an increased opportunity set for fundamentally-driven macro trading for the better part of the last three years.
Despite 100 basis points (bps) of discount rate hikes by the U.S. Federal Reserve (Fed), long-term rates remain low, and yield curves have flattened as investors expect monetary policy overall to remain highly accommodative for many years to come. Additionally, the European Central Bank (ECB) and the Bank of Japan (BoJ) are continuing to purchase assets, and global liquidity remains widely available. However, as time goes on and inflation moves above and beyond central bank targets, the pressure will build for policymakers to tighten monetary policy.
While the shift in the monetary policy framework is taking longer than expected, we see a clear path for the world’s central banks to gradually reduce their monetary stimulus, ultimately ending with the removal of the central bank-induced bid for risk assets. This could translate into a more attractive environment for global macro discretionary strategies, particularly if volatility and interest rates rise further. In general, higher levels of volatility lead to more opportunities to generate attractive returns from active trading, which is an important contributor to discretionary macro returns.
What could generate such volatility? There are a number of structural factors in today’s market that are weighing on volatility outside of the unprecedented actions of central bankers, including a broader switch in the markets from active to passive investing along with the proliferation of systematic volatility selling strategies. It is not clear what catalyst will bring volatility back to more historical levels, but the markets are increasingly vulnerable to a shock, economic or geopolitical, that would disrupt volatility selling strategies and trigger a material dislocation.
The biggest risk to an improving opportunity set for discretionary macro strategies would be for central banks to lose confidence in the recovery because of a softening in economic data or an equity market correction. However, as their confidence grows in the self-sustaining nature of the recovery, central bankers will be increasingly prepared to look through bouts of market volatility and continue to remove monetary accommodation.
The investment climate for discretionary macro investing is improving, but finding the right manager(s) within the discretionary macro sector is critical. Today, investors may have no shortage of options. Managers that are a bit smaller in asset size can be more tactical or nimble in executing upon their investment views. Additionally, managers that perform differentiated research or have a unique approach to trade structuring, provide further opportunities to generate returns in a non-consensus manner.
The timing of shifts in market paradigm is difficult, certainly on a consistent basis over time. It is for this reason that diversified allocations across strategies can protect portfolios during periods of market stress. Given the profile that discretionary macro strategies exhibit over time, combined with the anticipated paradigm shifts noted above, prudent investors could view the current environment as an opportunity to increase exposure to the discretionary macro strategies.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.
A version of this article was originally published in Seeking Alpha on January 9, 2018.
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