Global Macro Amid Uncertainty (ENG)
The elevated market correlations and shifting risk appetites of the past few months have created a challenging investing environment for most hedge fund strategies. Given the importance of macro considerations in driving the recent market moves, it is not surprising that strategies based on bottom-up approaches have suffered, while directional and tactical trading strategies have outperformed on a relative basis.
Von Mark van der Zwan and Radha Thillainatesan, Morgan Stanley Alternative Investment Partners:
The HFRI Macro strategy is one of the better performing strategies for the year through September, albeit with a negative return of -1.7% compared to -5.4% for the HFRI Fund Weighted Composite Index; and -8.7% for the S&P 500 Index. The stronger relative performance of macro during periods of market stress has been a key characteristic of the strategy. 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 effect, due to a stable diversification profile in periods of market turmoil.
During the recent credit crisis, the S&P 500 experienced a peak-to-trough drawdown of 51.0% 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%.
Recent times have highlighted to investors the unstable nature of correlations. During severe market dislocations, diversification benefits can quickly evaporate as correlations spike. Interestingly, the opposite effect has been true for macro strategies: correlations to equity indices have tended to decline 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 3 years preceding the credit crisis, the correlation was 49%. The 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.
Global macro’s relatively low downside correlation to other hedge fund strategies can be further understood through its lower exposure to: i) systematic liquidity risk and ii) systemic deleveraging risk. Many convergent hedge fund strategies estimate intrinsic values and expect that convergence to intrinsic value will occur over some time period. However, these strategies tend to experience challenges during periods of market illiquidity and market deleveraging. These risks are most notable during times of market crisis where deleveraging and a general flight to quality and liquidity have resulted in technical factors superseding fundamental factors.
Further, while many investment strategies are limited by specific asset classes, global macro’s inherent flexible approach allows the strategy to have a broad vantage point, therefore permitting tactical sector and instrument allocation when economic and market disequilibria present opportunities. This has allowed the strategy the opportunity to perform well in a range of economic environments.
This year, although the headline performance of the strategy is negative, there has been substantial dispersion of returns among managers and macro sub-strategies. In particular, there has been a notable divergence in returns between discretionary macro strategies, where the ultimate portfolio decisions are made by a human trader, and systematic macro strategies, where the bulk of the investment process is automated. In past crisis periods, discretionary macro strategies lagged those of systematic strategies; this time around, discretionary strategies as a group have generally outperformed and several prominent discretionary macro managers have posted strong returns.
The Quantitative Strategies subindex of the Newedge Macro Trading Index returned -2.8% for the year through September, while the Discretionary Strategies subindex returned about +0.2% for the year. We believe that this divergence is in part due to the increased relevance of government solutions in determining the direction of the markets. Discretionary traders, who can readily respond to shifts in policy and news flow, have benefited disproportionately, while systematic traders have suffered from a largely directionless market that has not conformed neatly to past trading patterns. Compounding the difficulties for systematic traders, there have not been strong medium term trends in many asset classes.
Over the long term, it is evident that there has been alpha from both the discretionary and systematic approaches, and that there are some clear trade-offs between the two. Discretionary managers can be expected to achieve greater efficiency at the individual trade level. This follows from their ability to incorporate both quantitative and qualitative inputs in their ideas, and structure trades that better capture specific opportunities. In contrast, the major benefit of systematic strategies typically lies in their ability to diversify across a number of markets and hence make up for weaker efficiency in any individual market through greater breadth and optimal combination of trades.
Systematic strategies have also tended to be better able to maintain positions through major crises, because trade decisions are made by models acting in a dispassionate way and are not susceptible to the typical behavioral biases of human investors. Previous periods of market stress typically coincided with predictable flows driven by the herding behavior of investors and the portfolio constraints of institutions. These types of flows can be readily exploited by technical analysis, and contributed to the strong performance from systematic macro strategies in 2008.
The key appeal of global macro – across both systematic and discretionary strategies – rests in its historically resilient risk/return profile and stable diversification characteristics relative to both traditional and alternative asset classes through periods of volatility and uncertainty. The strategy should be well positioned to weather the current market environment, given the presence of a range of new and still-unresolved macro factors that are influencing market dynamics.
The views herein represent the views of the authors as of the date of the publication and not as of any future date. The foregoing article should not be considered investment advice by or for any reader.
This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.
Mark van der Zwan, CFA, is a portfolio manager for Morgan Stanley Alternative Investment Partners Fund of Hedge Funds, focusing on global macro, multi-strategy, secondaries and quantitative strategies; he is also a member of the AIP Fund of Hedge Funds Investment Committee. He joined Morgan Stanley AIP in 2004 and has 16 years of industry experience. Prior to his current role, Mark was an investment analyst in AIP. Before joining the firm, Mark was a senior consultant for Alan D. Biller & Associates, an institutional investment consulting firm, where he was responsible for hedge fund manager selection. Previously, he was a researcher at the National Research Council of Canada, where he performed advanced computational modeling. Mark received both a B.Sc. with honors in chemistry and an M.B.A. in finance from Queen‘s University in Ontario, Canada. Mark holds the Chartered Financial Analyst designation.
Radha Thillainatesan is an investment analyst for Morgan Stanley Alternative Investment Partners Fund of Hedge Funds group, focusing on systematic strategies. She joined Morgan Stanley AIP in 2006 and has nine years of industry experience. Prior to joining the firm, Radha was a hedge fund analyst in the fund of hedge funds group at Larch Lane Advisors. Previously, she was a research assistant at the Center for Research in Neuroscience, Montreal. Radha received a B.S. in physiology from McGill University and an M.S. in mathematics from New York University.
Alternative Investment Partners (AIP), a division of Morgan Stanley Investment Management, manages portfolios of private equity, hedge fund and real estate investments on behalf of institutional and high net worth clients.