Amid increased volatility and broader market uncertainty, investors are looking for strategies with a track record for generating strong risk-adjusted returns.
In response, investors are seeking out strategies that have a track record for generating strong risk-adjusted returns in challenging markets. For certain investors, global macro strategies could be one component of a well-diversified portfolio. By taking positions—both long and short—in stocks, bonds, commodities, currencies and other assets, these strategies have the potential to outperform traditional approaches when markets are in flux.
“The thinking behind global macro investing is to capitalize on market dynamics unfolding anywhere on the globe and be in any market or asset class where there is opportunity," says Robert Rafter, Head of Discretionary Global Macro at Morgan Stanley Investment Management Alternative Investment Partners. “This means not just anticipating the next inflection point in a particular economy or a political change, but also being able to anticipate how various markets will respond to new developments."
Global macro managers employ many different investment styles and analytical inputs, across varying time horizons, but a common thread is to seek excess return by timing their exposures to different segments of the globe. While this approach tends to work well in a range of market environments and global macroeconomic scenarios, global macro managers have historically posted their best relative returns during market dislocations.
Between Jan. 1, 1990, and October 31, 2018, for example, the HFRI Macro Index delivered positive returns in 23 out of 28 full calendar years, according to Hedge Fund Research, Inc. Moreover, the index, which is a proxy for global macro strategies, returned an average of 9.71% a year—or nearly 10 basis points more per year than the Standard & Poor's 500—and with only half the volatility of the broader market.
In addition, global macro strategies have historically had low correlations to equity and bond markets—offering additional potential diversification benefits.
The conventional wisdom on asset allocation has been to spread one's bets across stocks, bonds and a smattering of alternatives, such as gold, real estate or commodities. Yet, the global financial crisis and other periods of discord revealed the shortcomings of traditional diversification strategies.
Global Macro Performance During Crisis Periods (01/1998 - 10/2018)
During the most devastating months of the crisis, in September and October 2008, stocks and bonds fell in tandem. The HFRI Macro Index returned +0.40% during this period.
HFRI Macro and S&P 500 12-month Rolling Correlation
Although global macro is designed to reduce overall portfolio volatility, challenging markets often play to their strengths. Again, that's because global macro managers aim to exploit inefficiencies, such as investor behavioral biases, divergent global business cycles, differences in central banking policy, and monetary policy shifts.
“Because the strategies themselves are not biased with respect to region or asset class, they can go where the opportunities are," says Rafter. “Meanwhile, macro strategies play in the most liquid parts of the market, so they have the potential to capture sudden and large changes in the market or market dynamics."
Global macro managers typically make allocation decisions based on changes in macroeconomic outlooks, policies or investor perception. Exactly how they arrive at these views varies widely. Fundamental managers, for example, evaluate opportunities based on such criteria as relative valuations, economic forecasts, fiscal policy, and outlooks for interest rates or currencies. Technical managers, meanwhile, might rely primarily on quantitative models that spot predictive signals based on historic market price patterns.
The same is true for how they execute their ideas. Systematic managers tend to adhere to a rules-based approach that determines weightings, timing and position sizes. Discretionary managers, on the other hand, typically form and execute their views by combining analytical tools and processes with qualitative assessments and experience.
Global macro strategies have the potential to enhance risk-adjusted performance and improve overall diversification when added to a portfolio of traditional investments, alternative investments, or both. The challenge, however, is selecting global macro managers with the skill to generate returns on a consistent basis across market cycles.
For this reason, we believe many investors opt for multi-manager investment vehicles run by specialists in manager selection, portfolio construction, dynamic asset allocation and risk management techniques. Such vehicles mitigate the idiosyncratic risk that accompanies standalone hedge fund investments by providing diversification across managers, strategies and investment styles.
“For investors, this should translate to a more effective and diversifying exposure than what they might see by investing in only a few global macro managers," Rafter notes. In the end, that can provide stronger risk-adjusted returns and better ballast for a portfolio, no matter what the macroeconomic backdrop.
The following are among the risks applicable generally to a portfolio of hedge fund investments:
Reliance on Third-Party Management. The goal of investing in a portfolio of hedge funds managed by an investment adviser is to seek capital appreciation. Hedge funds selected for the portfolio are managed by third-party managers unaffiliated with an investment adviser over which an investment adviser does not exercise control.
Wide Scope of Investment Options Available to Third-Party Managers. Hedge funds may invest and trade in a wide range of instruments and markets and may pursue various investment strategies. Although hedge funds will primarily invest and trade in U.S. and non-U.S. equity and debt securities, they may also invest and trade in equity-related instruments, currencies, financial futures and debt-related instruments. In addition, hedge funds may sell securities short and use a wide range of other investment techniques. Hedge funds are generally not limited in the markets in which they may invest, either by location or type, such as U.S. or non-U.S. markets or large- or small-capitalization companies, or in the investment discipline which their investment managers may employ, such as value or growth strategies or bottom-up or top-down analysis. Hedge funds may use various investment techniques for hedging and non-hedging purposes. A hedge fund may, for example, sell securities short, purchase and sell options and futures contracts, and engage in other derivative transactions. The use of these techniques may be an integral part of the hedge fund’s investment strategy and may involve certain risks. Hedge funds may use leverage, which also entails risk.
No Assurance of Returns. The investment program of a portfolio of hedge funds is speculative and entails substantial risks. No assurance can be given that its investment objective would be achieved. Its performance depends upon the performance of the hedge funds included in the portfolio and upon the ability of the Investment Adviser effectively to select hedge funds and allocate and reallocate the portfolio’s assets among them. Each hedge fund’s use of leverage, short sales and derivative transactions, in certain circumstances, can result in significant losses, volatility, or both.
Performance-Based Compensation. In addition to asset-based fees based on the hedge fund’s net assets under management, a hedge fund’s investment manager will typically charge each of the hedge fund’s investors a performance or incentive fee or allocation based on net profits of the hedge fund which it manages. Similarly, in addition to asset-based fees based on the portfolio’s net assets, the Investment Adviser or one of its affiliates will also receive performance-based compensation (the “Performance Incentive”). The receipt of a performance or incentive fee or allocation by a hedge fund’s investment manager or of the Performance Incentive by the Investment Adviser or one of its affiliates may create an incentive for the hedge fund’s investment manager or the Investment Adviser, respectively, to make investments which are riskier or more speculative than those which might have been made in the absence of such an incentive.
Lack of Transparency. Hedge funds are not registered as investment companies with the U.S. Securities and Exchange Commission (the “SEC”) under the Investment Company Act of 1940 (the “ICA”), and investors in hedge funds will not have the benefit of the protections afforded by the ICA to investors in registered investment companies.
Although the Investment Adviser will periodically receive information from each hedge fund in which the portfolio is invested regarding such hedge fund’s investment performance and investment strategy, the Investment Adviser may have little or no means of independently verifying this information. Hedge funds are not contractually or otherwise obligated to inform their investors of details surrounding proprietary investment strategies. In addition, the Investment Adviser has no control over the investment management, brokerage practices, custodial arrangements or operations of hedge funds and must rely on the experience and competence of each hedge fund’s investment manager in these areas.
Multiple Levels of Fees and Expenses. By investing in a portfolio of hedge funds managed by the Investment Adviser, an investor bears its proportionate share of the asset-based fees and the Performance Incentive payable to the Investment Adviser and any of its affiliates, as the case may be, as well as other expenses of the portfolio. An investor, however, also indirectly bears its proportionate share of the asset-based fees, performance or incentive fees or allocations, and other expenses borne by investors in the hedge funds included in the portfolio. An investor which meets the eligibility conditions imposed by the respective hedge funds included in the portfolio, including minimum initial investment requirements which may be substantially higher than those imposed by any fund, could avoid the extra layer of fees and expenses by investing directly in those hedge funds.
Independence of Hedge Funds’ Investment Managers. A hedge fund’s investment manager will receive any performance or incentive fees or allocations to which it is entitled, without regard to both the performance of the other hedge funds in the portfolio and the performance of the overall portfolio. An investment manager to a hedge fund with positive performance may receive compensation, even if the overall portfolio’s aggregate returns are negative.
Potential for Increased Transactions Costs. Investment managers of the hedge funds included in the portfolio make investment decisions independently of each other. Consequently, at any particular time, one hedge fund in the portfolio may be purchasing interests in an issuer which at the same time are being sold by another hedge fund in the portfolio. Investment by hedge funds in this manner could cause the overall portfolio to incur certain transaction costs indirectly without accomplishing any net investment result.
Limited Liquidity of Hedge Funds. Additional investments in, or withdrawals from, the hedge funds in the portfolio may be made only at certain times, as specified in the governing documents of the respective hedge funds. As a result, before investments in hedge funds are effected or in furtherance of the portfolio’s objectives generally, some assets held in the portfolio may temporarily be from time to time cash, cash equivalents, or high-quality fixed-income securities and money market instruments (whether or not managed by affiliates of the Investment Adviser).
Limited Voting Rights of Investors. A hedge fund typically restricts the ability of its investors to vote on matters relating to the hedge fund. As a result, investors in the hedge fund will have no say in matters which could adversely affect their investment, via the portfolio, in the hedge fund.
Distributions in Kind. Hedge funds may distribute securities in kind to investors. Securities distributed in kind may be illiquid or difficult to value. In the event that a hedge fund were to make such a distribution in kind to a Fund, the Investment Adviser would seek to dispose of the securities so distributed in a manner which is in the best interests of such Fund.
Reliance on Third-Party Managers with Respect to Asset Valuation. Certain securities in which a hedge fund invests may not have a readily ascertainable market price and will be valued by the hedge fund’s investment manager. Such a valuation generally will be conclusive, even though the hedge fund’s investment manager may face a conflict of interest in valuing the securities, inasmuch as the value of such securities will affect the compensation payable to the hedge fund’s investment manager. In most cases, the Investment Adviser will have no ability to assess the accuracy of any such valuation. In addition, the net asset values or other valuation information received by the Investment Adviser from hedge funds will typically be estimates only, subject to revision until completion of the annual audits of the respective hedge funds. Revisions to the gain and loss calculations will be an ongoing process, and no net capital appreciation or depreciation figure can be considered final until completion of the annual audits of the respective hedge funds.