Why are Global Macro hedge funds struggling?
The first hint: everybody is now a global macro investor (or wants to be).
Here’s the backdrop:
1. Global Macro hedge funds performed poorly since about mid-2010. Performance continues to be lackluster (paragraph nine);
2. The category is now in net redemption mode;
3. Some, like Moore Capital, are preempting investor discontent by returning money to them;
4. Most seem to be doing their best to milk the 2 percent management fee for as long as investors allow.
How did we get to this point?
First, a bit of history. Pre-crisis, there were three basic types of global macro players. There was Old School Macro. Think George Soros. There were many others. These guys placed massive, fundamentally-driven bets and would come back in X months’ time to see if they broke the Bank of England or whatever. They tolerated huge P&L swings. These were the guys who made global macro sexy.
Then came New School Macro. These guys mostly grew up in the investment banks, either as prop traders or flow traders, or both. Their motto is risk management über alles. These funds—though they are loath to admit it—are driven by risk management much more than by fundamental ideas. They have tended to inhabit the more liquid end of the investment spectrum and manage drawdowns aggressively.
Lastly, there has been the steady growth of Tourist Macro. These are the guys whose expertise was in another market sector, such as credit (e.g. John Paulson) or long-short equity (e.g. David Einhorn), who became enamored of a macro view (short Europe, long gold, short US Treasuries, etc.) and placed big bets, Old School style. The common denominator was that they were bottoms-up guys who got seduced by top-down ideas. And below these marquee managers there is no shortage of erstwhile bottoms-up guys who have been assiduously trying to rebrand themselves as global macro thinkers or strategists.
After the crisis, several things happened. One, Old School Macro quietly went away. Some blew up. Many discovered that the new class of hedge fund investor couldn’t stomach the P&L volatility that came with their style. Others converted to family offices to avoid, inter alia, the hassle of defending their positions to fund-of-fund MBAs armed with sharp ratios.
Two, New School Macro came into its own. Performance in the crisis was good, most of them didn’t “gate”, or lock-up investors when the crisis hit, and they held out the promise of managing drawdowns aggressively. All this, plus the strong instinct to chase returns, made New School Macro look pretty good when investors gazed at them through their rear view mirrors.
The inflows into New School Macro and the nature of the fundamental events unleashed by the crisis increased massively the popular focus on macro issues. This, in turn, fed the growing trend toward Tourist Macro. Everyone constantly talked global macro. Everyone wanted to be global macro.
Why does this matter today?
The attention on and inflows into global macro, coupled with the risk management style of the New School, has produced the choppy (rip, then air pocket; air pocket, then rip) market with high correlations across asset classes that we have come to know all too well in the past two years. Why? Because New School global macro feels enormous pressure to take risk and justify management fees. They need to be involved when the market is moving—especially when the S&P is going higher (“You are getting paid to take risk. So, take risk”). But they also have promised their investors that they will manage their downside aggressively if their positions turn against them.
Having to be in the market, but not being able to stomach drawdowns is what has led lots of large players to stop in at local highs and stop out at local lows; broadly the same positions, broadly at the same time. It has been hugely frustrating for them. But this is largely where the high-correlation choppy market has come from.
How can an investor take advantage of this?
This dynamic will persist until the strategy falls enough out of favor that the big inflows of 2009-2010 flow back out (which has started to happen), or other investors emerge that can “arbitrage” the herd.
The way to arbitrage the herd is to be able to keep your bat on your shoulder for months at a time if necessary, and deploy capital in the assets you fundamentally like when the dislocations from the global macro chop fest eventually materialize. And they will materialize. Then, when you do commit, widen your stops so as to increase your staying power.
It sounds simple, but any professional hedge fund manager will tell you (perhaps only after the application of sufficient sodium pentothal) that running less than say 30-40% of targeted VAR (or whatever your risk benchmark is) for any meaningful length of time is next to impossible if you are clipping 2 percent management fees.
(Lastly, a pro tip: When a global macro investor tells you he expects to see greater market “differentiation” going forward, he is really saying the global macro equivalent of “it’s a stock-picker’s market”. Caveat emptor.)