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By Karl Mergenthaler, CFA, Stacey Parke, and Ryan Holgan According to the Chinese Zodiac, 2011 was the Year of the Rabbit. As such, it was supposed to be a relatively serene and non-confrontational year. So much for astrology. During 2011, financial markets were characterized by sharp and unpredictable mood swings ignited by a multitude of macroeconomic events. The year's headlines seemed to jump from one major issue to the next – Japanese earthquake, Arab Spring, U.S. debt ceiling debate, European sovereign debt crisis. Meanwhile, investors grappled with the high correlation among asset classes. Notably, the "Risk on / Risk Off" trade seemed to move markets and affect multiple asset classes as traders gauged risk based on macro-economic events. In this environment, institutional investors have an ever-increasing menu of choices to capitalize on opportunities in the financial markets. In addition to the thousands of traditional long-only managers of stocks and bonds, there are an estimated 10,000 hedge funds in the United States accounting for approximately $2 trillion in assets. There are more than 1,100 Exchange Traded Funds (ETFs) with assets totaling about $1.1 trillion. Meanwhile, the explosion of electronic and algorithmic trading has accelerated the pace of activity in the financial markets. Many institutional investors are looking to global macro hedge funds in search of high risk-adjusted returns and diversification benefits. According to Preqin, approximately 25% of institutional investors gave preference to macro-oriented hedge funds.1 During 2011, launches of new macro funds accelerated, representing nearly 35% of all single manager launches in the second half of 2011 according to Hedge Fund Research.2 The J.P. Morgan Investment Analytics and Consulting group reviewed the major financial markets in which global macro funds participate. We analyzed the long-term performance of global macro hedge funds, particularly in periods of market turmoil. Our analysis suggests that global macro hedge funds may provide attractive risk-adjusted returns within the context of institutional portfolios. A Volatile and Diverse Opportunity Set Broadly speaking, global macro managers attempt to generate alpha based on macro-economic events. Although the strategies may vary, the managers typically express their views through numerous long and short positions across equity, fixed income, foreign exchange, commodity and other markets. We believe the current volatility in many financial markets should provide ample opportunity for global macro hedge funds to add value. Over the past year, domestic and international equity markets have presented many challenges and opportunities to hedge fund managers. In the middle of 2011, equity market volatility spiked with the VIX hitting 48 on August 8. Moreover, there was a large disparity of returns among different regions as large cap domestic stocks were up modestly for the year, while emerging market equities declined by double digits. Clearly, global macro players had an opportunity to add value by managing volatility, timing their positions and selecting the best performing regions. In the beginning of 2011, few fixed income analysts would have predicted that the yield on the 10-year U.S. Treasury bond would fall below 3%. Nonetheless, the yield curve flattened as rates on longterm U.S. sovereign debt fell despite a downgrade from Standard & Poor's. When "Operation Twist" was announced in September, the 10- year Treasury rate hovered around 2%. To the surprise of many, the rates on the long-end of the treasury yield curve continued to flatten, driving bond prices up and generating returns in 2011 of 17.2% and 35.6% on the 10-year and 30-year U.S. Treasury bonds, respectively. Credit spreads between corporate and emerging debt issues widened as did the spread between German Bunds and the sovereign debt of peripheral countries. Clearly, savvy fixed income investors had many opportunities to generate alpha through tactical positions in sovereign and corporate debt markets. Global macro hedge funds and other players actively participate in the foreign exchange markets. The FX market is one of the most liquid financial markets in the world with average daily turnover of approximately $4 trillion. According to the Bank for International Settlements, daily turnover in the foreign exchange market has doubled over the past decade. Moreover, almost half of the turnover in the foreign exchange market is attributable to "other financial institutions – a category that includes non-reporting banks, hedge funds, pension funds, mutual funds, insurance companies and central banks."3 It seems clear that financial players impact the liquidity and volatility of the foreign exchange markets. In this market, global macro funds should have an opportunity to generate out-performance with trading skill and timing. Likewise, commodity markets were volatile during 2011. Consider cotton, for example. The price of cotton doubled in less than a year to a peak of $2.15 per bushel in March 2011, only to fall to less than $1.00 per bushel in July 2011. Surely there are supply and demand factors that affect the price of cotton. Moreover, it seems likely that financial players including global macro hedge funds and others, may have impacted the volatility in the commodity prices over the past year. Performance of Global Macro Funds In recent years, the aggregate performance of global macro funds has been mixed. The HFRI Macro Index generated returns of -3.6% and 8.69% for the one and three year periods ended December 31, 2011. It is interesting to compare the performance of global macro funds relative to performance in equity, fixed income, foreign exchange, and commodity markets. On the following page, we illustrate the median market performance of global macro hedge funds versus several representative markets. As illustrated in Exhibit A, global macro managers, represented by the HFRI Global Macro Index, significantly outperformed other hedge fund strategies as well as the equity and fixed income markets throughout the 2008 credit crisis. Macro strategies were able to maintain a positive absolute return throughout the majority of the past decade even during periods of market distress. It seems reasonable to assume that global macro funds should thrive in an environment where there is significant dispersion among the various major asset classes. We analyzed the performance of global macro hedge funds during periods of historical market turmoil. In Table 1, we compare the return and volatility of macro hedge funds as compared to other strategies during the 2008 financial crisis and the recession of the early 2000s. As shown in Table 1, macro hedge funds delivered on their promise of contributing positive returns with relatively low volatility (standard deviation) during periods of market stress. The superior risk-adjusted returns during recessions can be explained by macro funds' ability to actively trade across global asset classes. As the desire for less systematic risk exposure increases during times of high market volatility, many pensions, endowments and other institutions are looking at the low correlation that hedge funds have to the equity markets. Based on our analysis, we believe that global macro funds may contribute attractive diversification benefits to institutional investors. In the chart below, we summarize the correlation of global macro managers to the other major traditional and alternative asset classes. Exhibit A: Global Macro Market View larger image.
Source: J.P. Morgan, Russell, Bloomberg.
View larger image.
Source: Bloomberg, Hedge Fund Research, Inc. and J.P. Morgan
Table 2: HFRI Macro Index - Asset Class Correlations Source: Bloomberg, Hedge Fund Research, Inc. and J.P. Morgan
As displayed in Exhibit B, our analysis indicates that macro funds provide diversification benefits relative to equity markets during difficult periods. The periods shaded in white represent economic recessions in the United States, which coincide with poor performing global equity markets. As evident in Exhibit B, the correlation between the HFRI Macro Index and the various equity indices dips into negative territory in and around these recessionary periods. This provides further evidence that global macro hedge funds may provide diversification during the difficult periods, when institutional investors need it most. Exhibit B: One Year Rolling Correlations: HFRI Macro Index versus Equity Indices View larger image.
Source: Russell, MSCI, Hedge Fund Research, Inc. and J.P. Morgan
There are a wide range of styles and strategies that fall within the broad "global macro" category. Global macro managers may rely on fundamental analysis of economic data such as interest rates, exchange rates, and GDP growth. Alternatively, some macro managers may focus on technical patterns or other indicators. Global macro hedge funds may rely on the discretionary judgment of portfolio managers, or employ a quantitative, systematic approach. Invariably, there is likely to be a significant amount of manager-specific risk in this category. Concurrent with increased volatility across financial markets, there is a wide dispersion between top- performing and bottom-performing funds within the global macro manager universe. Often times, hedge fund composite performance masks sizeable performance dispersion between and within styles. According to the Man Group Plc., the global macro universe is estimated to have produced a performance range of around 62 percentage points from a peak of +38.7% to a trough of -23.2%.4 Thus, manager selection within the macro universe is crucial. Table 3 details the top performing global macro hedge fund strategies through October 2011, as reported by Bloomberg Markets. As indicated in Table 3 many macro funds have been able to generate attractive returns over the past two years. We believe plan sponsors should closely analyze and monitor the attribution of global macro hedge fund manager returns. In our view, attribution analyses may uncover subtle changes to strategy or risk profile. Given that global macro funds participate in a variety of asset classes, investors should attempt to determine whether the manager has the ability to consistently generate returns from the markets in which it operates. In all cases, investors should use attribution analysis to determine whether a given global macro strategy is likely to produce returns in a repeatable fashion. Table 3: Top 10 Performing Global Macro Hedge Funds as of October 31, 2011 View larger image.
Source: Bloomberg Markets
During periods of elevated market turmoil within the last decade, especially in the public equity markets, the market volatility and wide range of returns experienced amongst asset classes provided fertile hunting ground for global macro managers. With an abundant global opportunity set of investments and low correlations to other asset classes, macro funds have delivered higher risk-adjusted returns than other hedge fund strategies during recessions. The vast opportunity set has enabled macro funds to outperform and provide diversification benefits during periods of economic contraction. The top performers of the macro hedge fund universe were able to capitalize on the market opportunities and generate positive returns for the majority of the last decade. Global macro managers seem to de-couple from traditional asset classes during periods of market turmoil as illustrated by their rolling correlations to alternative asset classes. As such, we believe institutional investors should consider global macro funds within the context of a diversified portfolio. In that same vein, one may consider global macro hedge funds as an appropriate hedging strategy during recessions as macro funds have maintained a positive alpha when downside risk is prevalent. As we look forward, we can only wonder what 2012 – The Year of the Dragon – will bring.
1 Preqin Newsletter May 2011 |
