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October 16, 2019
Managing Downside Risk with Global Macro Strategies
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October 16, 2019

Managing Downside Risk with Global Macro Strategies


Investment Insight

Managing Downside Risk with Global Macro Strategies

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October 16, 2019

 
 

Amid concerns about potentially unsteady and down markets, we believe two of the strategies employed by global macro managers are particularly worthy of consideration today: long volatility and tail risk.

 
 

What is Global Macro?

Global macro is an investment style that is very diverse: Managers have the flexibility to take long or short positions in any global market using any liquid financial instrument. These strategies can be highly opportunistic and have the potential to generate strong risk-adjusted returns in challenging markets.

 
 

Designed to Behave Differently

Historical spikes in market volatility and major inflection points in central bank policy measures have shown us that correlations among asset classes are not stable. Indeed, during severe market dislocations, diversification benefits across asset classes can quickly evaporate as correlations spike. Historically, global macro has bucked this trend. For example, as illustrated in Display 1, correlations between global macro, as proxied by HFRI Macro (Total) Index, and U.S. equities actually decreased during the technology bubble and the credit crisis. Looking across asset classes more broadly, global macro has historically exhibited relatively low correlation to bond markets as well as to other hedge fund strategies, particularly in crisis periods (Display 2).

 
 
 
DISPLAY 1: Historical Correlation Between Global Macro and U.S. Equities
9664044_Web-Display1
 

Source: Bloomberg and Hedge Fund Research Inc.
Provided for illustrative purposes only. Past performance is not indicative of future results.

 
 
 
DISPLAY 2: Global Macro Has Exhibited Low Correlation to Other Strategies
9664044_Web-Display2
 

Source: Hedge Fund Research Inc. for HFRI indexes; Bloomberg for all other indexes.
Provided for illustrative purposes only. Past performance is not indicative of future results.

 
 

Performance in Challenging Markets

On an absolute return basis, global macro has tended to hold up well during market crises (Display 3) as such market conditions often give rise to attractive trading opportunities on which global macro managers can potentially capitalize.

 
 
 
DISPLAY 3: Global Macro Performance During Crisis Periods
9664044_Web-Display3
 

Source: Hedge Fund Research Inc. for HFRI global: indexes; Bloomberg for all other global: indexes.
Provided for illustrative purposes only. Past performance is not indicative of future results.

 
 

Indeed, certain global macro strategies are designed with the aim of outperforming in precisely these sorts of environments (Display 4). Among the most notable of these are dedicated long volatility and tail risk strategies.

 
 
 
DISPLAY 4: Illustrative Market Return Distribution
9664044_Web-Display4
 

Provided for illustrative purposes only.

 
 

A Closer Look at Long Volatility Strategies

A closer look at the historical performance of long volatility and tail risk strategies reveals dramatic downside risk mitigating characteristics (Display 5).

 
 
 
DISPLAY 5: Historical Down Capture Statistics
9664044_Web-Display5
 

Provided for illustrative purposes only. Past performance is not indicative of future results.

 
 

Long volatility strategies have a high degree of exposure to, or a long bias to, the level of market volatility. They tend to exhibit positive correlation to market volatility and negative correlation to equities over most time horizons. In other words, they are designed to seek to deliver positive returns during periods of market turbulence. Historically, they have delivered.

“Tail risk” strategies comprise a subset of the long volatility universe that exhibits a high degree of convexity, a level of payout that is outsized in comparison to the change in an underlying variable, to large increases in market volatility or declines in equity prices. They are characterized by opportunistic and hedging positions that are intended to deliver positive returns during dramatic market declines. As shown in Display 5, they too have historically proven successful over time.

The Cost

Of course, no investment strategy is without risk or cost. Long volatility strategies tend to be structured with options and other insurance-like products. Options are highly liquid derivative instruments that allow investors to target very specific exposures—for instance, a specific commodity, currency or index— but the cost of holding them in benign markets is not insignificant (Display 6).

 
 
 
DISPLAY 6: Return Payoff Histogram
9664044_Web-Display6
 

Provided for illustrative purposes only.

 
 

Tail-risk strategies tend to be less costly to carry. Benefiting from greater convexity profiles, their potential payoffs can be considerably larger than long volatility exposures. However, those payoffs would only occur during more extreme market conditions.

While the potential benefits of these strategies are clear, it is important to determine the appropriate size of an allocation. Investors will want to be sure that the peace of mind and potential payoff provided by these strategies make sense in the context of associated costs and the portfolio’s overall target return and volatility level.

Conclusion

Over time, global macro has demonstrated its ability to perform differently from other asset classes and to weather difficult market conditions, making it, in our opinion, a valuable component of any well-diversified portfolio.1 In addition, we believe that long volatility strategies, including tail risk strategies, have the potential to reduce drawdowns in investor portfolios during volatility shocks and market downturns by seeking to generate positive returns amidst market dislocations.

 
 

1 Diversification does not eliminate the risk of loss.

 
 
 
 

GLOSSARY

High Convexity: Positive return expectation (payoff profile) in crisis markets

Negative Carry: Negative returns during normal market

Sharpe Ratio: A measure of an investment’s return versus the risk required to achieve it

Theta Decay: A measure of the rate of decline in the value of an option because of the passage of time.

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