Much has been made recently of the struggles faced by ‘macro’ managers in recent years, particularly among hedge funds. The last five years have seen relatively low returns to these strategies both in an absolute sense, but most notably relative to global equity markets.
The perceptions of poor performance have intensified since the pivotal moment in markets last summer.
There have been two related attempts to explain this phenomenon. The first argument is that ‘macro’ as a strategy is based on economic forecasting, that forecasting is a built on pseudo-science, and that therefore we should never expect macro strategies to work.
The second is specific to the current environment; it points to the effects of QE and holds that macro managers have either simply been ‘wrong’ in not backing the obvious upward trend in equity markets that would result, or that the distortionary effects of central bank policy has made forecasting macro trends impossible.
Our view is that these are partial explanations at best – ultimately what is more interesting is what the performance of these funds, and especially how they are interpreted, tell us about how the investment landscape has changed over the last twelve months.
We would question the view that macro investing goes hand in hand with forecasting. Readers of our blog or those familiar with our philosophy will know that we are deeply sceptical of forecast-led approaches.
In the Bloomberg piece, a macro manager who has recently closed his fund notes with frustration the times when he “got his forecasts right but market predictions wrong.” Our view is that this is not a function of today’s environment, but the normal way of things: it has always been the case that perceptions of risk and the starting point of value are periodically far more important than changes in the underlying fundamentals.
In short, investors used to look for one set of outcomes in macro strategies and are now looking for another.
What is really going on?
Ultimately the failure of many macro funds is a function of the same type of thinking that has permeated the investment industry since 2000, and especially since 2008. For much of the last ten years many investors have had a perspective that capital preservation is a priority over generating returns. Having been brutally reminded of the risks that can go hand in hand with equity and credit investment, investors have been terrified of short term volatility.
Because macro allows for flexible ‘go-anywhere’ mandates, investors have therefore put a premium on anyone that can demonstrate negative correlation with equity (or in some cases, with all traditional assets classes). Macro became associated with strategies that protected, or better still were negatively correlated with ‘risk’ (where risk is taken to mean abrupt capital loss, even when it is temporary).
Macro managers were incentivised, and made to feel clever or popular, by avoiding risk and demonstrating an ability to make money out of drawdown phases. Funds that have done this have grown in size, while any sign of positive correlation with equities has been punished.
Considering the developments above, it is no surprise that the largest macro funds today will not have kept pace with equity markets – that is simply not what they have been incentivised to do.
However, the nature of strategies that have an absolute return mentality is that the benchmark ‘goal posts’ are always moving. Having now gone through a phase in which the ‘risky’ assets that no-one wanted to touch have delivered an extended period of strong returns (because of the very volatility aversion that existed in the first place), perceptions of risk have begun to change. “Risk” ceases to mean short-term volatility, and gradually shifts to the risk of “missing out” on returns. As the articles above demonstrate, low returns quickly become disappointing and are compared with the higher returns on the very same traditional assets that investors did not want to be correlated with in the first place; capital preservation takes a back seat.
After years of warning about a low return world and the inherent risk of equities, the narrative has changed to one in which the gains we have seen in equity markets were ‘obvious’ and that macro managers that have not ridden this wave have made a catastrophic error.
This marks the early stages of a shift to a new convention. In the US it has been very costly to have avoided equity over the last five years, there have been very strong real returns from corporate bonds and equities, while cash has been negative and government bonds close to flat.
Last year I wrote about how there were signs that we had reached a pivotal moment in investor perceptions and that the opportunity costs of hiding from volatility were becoming telling. This is still at an early stage, investors we talk to still show deep interest in a strategy’s potential equity correlation but nothing like the same concern that it could be correlated with bonds.
In the UK and Europe it is also the case that the opportunity cost of avoiding volatility has yet to be felt to the same extent (except from real cash losses).
However, with yields at their current levels, it seems like that pain is fast approaching.
Where does this transition leave macro strategies?
Some will legitimately note that the place of macro strategies in some portfolios may be as a supplement to exposure to traditional assets, and that looking for a lack of correlation over the long term is necessary to justify their inclusion. However, this doesn’t square with the argument that macro strategies have failed because they have not kept up with the equity rally.
The reality is that the convention over what makes a successful macro strategy is already changing. Human beings can’t help themselves, they are attracted to things that have been working, and there is a collective psychology at work in the assessment of investment strategies just as there is for all boom and busts. The crowd agrees on a new convention (for example, the need for negative equity correlation is still trotted out in a knowing confident manner), becomes emotionally wedded to it, and only gives it up reluctantly after an extended period of repeated evidence that it is wrong.
Nor is it inappropriate that these changes should take place; any macro (or other absolute return) strategy that is worth its salt needs to be able to adapt to a changing environment. A time-varying and direction-varying exposure to a broad range of assets is critical. There should be no shame of being positively correlated to the best performing assets, so long as this is not a static feature of an approach.
Rather, macro strategies need to be prepared to identify those assets which are priced to deliver high or above average returns and avoid those which offer low or negative returns. This involves observing how valuations change over time, and how the ‘odds’ are put in your favour when compensation for total risk – and not just short-term volatility – changes. Targeting the correlation with a single asset in this context is absurd.
We have just seen that regimes don’t only take place in terms of investment opportunities but also in the demands of investors and what is perceived as a ‘good outcome’ for macro strategies. To deal with this, macro funds need to be truly flexible and, importantly, cognisant that what investors want today may not be the same criteria on which they measure your performance tomorrow.