Replicating a winning formula proves tricky

Flexible and opportunistic global macro funds are being tipped to outperform other hedge fund strategies in the short to medium term. According to a recent survey by Deutsche Bank, institutional investors believe global macro will be the best performing hedge fund strategy in 2009. Of the respondents, 47% said they intended to allocate additional capital to the strategy over the course of the year.

What is undisputed is the strategy's performance in 2008 as one of the better performing, down only 4.62% for 2008 according to the index, and up 2.73% for the first quarter of 2009.

The defining characteristic of global macro funds is their ability to anticipate and profit from price trends and spread moves by analysing economic and political factors. Macro funds have a mandate to switch quickly between asset classes or change their trading positions in response to shifts in the economic or political landscape.

This makes them an ideal vehicle to capture return opportunities in a world characterised by unprecedented government intervention and major changes in the fundamentals of the market, according to Ben Gill, portfolio manager of the LGIM Global Macro Fund at Legal & General Investment Management.

"For the best part of this decade, fund management has been all about micro-level analysis, focusing on individual companies and specific events like mergers and acquisitions," he notes.

"That has completely turned around. It is now much more important to look at the impact of macro factors such as interest rates, inflation, fiscal and monetary policies and central bank intervention to identify investment opportunities," Gill says.

The LGIM Global Macro Fund makes high-conviction investments based on its assessment of macro-economic factors. "We only take a position if we have a strong view on it and find the risk/reward characteristics to be compelling," says Gill.

In 2008 the fund focused on short-term interest rates, but has now switched its attention to foreign exchange and stock indices. LGIM is also monitoring the impact of quantitative easing on economies around the world.

This type of investment approach harks back to the heyday of global macro when free roaming discretionary managers like George Soros and Julian Robertson made sweeping bets on major market events. Soros famously made a $10 billion bet that the British pound would be forced out of the European Exchange Rate Mechanism in 1992. He pocketed a $1 billion profit when the Bank of England was forced to devalue the currency.

Paul Lambert, manager of the Polar Capital Discovery Absolute Return Fund and director of macro/currency strategies at Polar Capital, says some of the qualities that made global macro synonymous with hedge funds in the 1980s and 1990s hold true in the current market. "Funds that can be one step ahead of developments and take smart contrarian views will make money in this type of market," he says.

He says managers must be ready to react quickly to events that change the economic view of the fund in order to be successful. The Polar Fund has historically taken more risk in foreign exchange than in other areas, but has adapted the strategy to take advantage of changing market conditions, says Lambert.

"In the last three to six months the fund has been taking bigger positions than usual in fixed income and equities. This is an example of using the flexibility of the strategy to produce the best returns," Lambert notes.

Lambert believes the global economy will see a slight recovery. "The world is slowly emerging from recession but the recovery will be weak. People have not fully realised the repercussions of the past 15 years. It was a period of unprecedented leverage. The world will not return to that sort of environment in the foreseeable future," he explains.

But not all global macro managers make big predictions about the economy. One of the features of the global macro universe is the sheer diversity of the investment styles it encompasses.

Eric Lonergan, manager of the M&G Episode Fund at M&G Investments, believes an approach that focuses on probabilities, psychologies and market pricing is most likely to produce consistent returns. "We do not put a high degree of emphasis on economic forecasting," he says.

"Dogmatic views on the economy are not the best way to make returns when the economy is going through such a turbulent period. A focus on probabilities and odds allows the fund to exploit shorter-run phases of price volatility," he continues.

The M&G Episode Fund exploits the impact of large macro-economic episodes or price-related shocks to the global system. "These shocks tend to leave people confused. It changes their beliefs and leads to an unusual price behaviour. We pay attention to these behaviours and psychologies and exploit anomalies in the market. The aftermath of these events is usually fertile ground for macro strategies," says Lonergan.

He believes global macro funds will post strong returns for the foreseeable future because macro-economic episodes will be a continuing theme in the global economy.

Mikkel Thorup, founding partner at Capricorn Asset Management and manager of the Capricorn FXG10 Segregated Portfolio, views global macro as principally a directional, trend-following strategy. Capricorn chases opportunities which are either going up or down. He says returns were hard to come by in the first quarter of 2009 because markets were choppy.

"I believe we are currently experiencing a bear market rally and there will be a downturn again in equity markets. This will lead to a clear trend which will be helpful to global macro managers," he says.

Diversity benefits
Thorup highlights the diversification global macro offers to investors through exposure to a wide range of instruments and markets as its main selling point.

"Managers can have positions in more than 50 markets at the same time if they choose. The return-generating opportunities are not that plentiful for hedge funds at present, but when you have the ability to pick and choose the best potential returns in any market, you have a greater chance of success," he says.

Steve Cleal, who manages the Aviva Investors Global Macro Fund, highlights the importance of investing in liquid instruments. "Trading in liquid markets gives global macro funds the ability to pursue short-term objectives," he says.

Cleal's approach is to analyse factors like inflation, interest rates and economic growth to determine their impact on liquid asset classes. "I believe it is important to understand where the economy is in a cycle in order for our fund to predict where asset prices are heading," he says.

His current assessment is that the global economy will improve slightly in the fourth quarter of 2009. "Most economies have been boosted by the aggressive fiscal and monetary policies pursued by governments to address banking sector problems and high levels of debt," he says.

"Our macro view is that the stage is set for a recovery, but I believe it will be a sub-par period of growth because banks will be reluctant to extend credit to individuals and debt levels will remain high. This will have clear implications for the instruments we trade," confirms Cleal.

Castlestone's Porcupine Global Macro Fund emphasises capital protection and liquidity. Leon Diamond, co-portfolio manager of the fund, says the flexibility of the strategy means the fund can take an overall defensive position and still generate attractive returns by taking liquid positions with strong risk/reward characteristics.

"The volatility in global markets has led to pricing anomalies in many markets across the investment universe. Global macro managers are present in many of these markets so they are best placed to exploit these opportunities," he says.

Third Wave Global Investors, based in Greenwich, Connecticut, runs a global macro fund with an emphasis on risk controls. Most of Third Wave's asset allocations are in pair-wise country trades.

The fund may be long or short a specific market but the equity beta of the total portfolio is typically close to zero. This allows the firm to minimise downside risk during times of high volatility and correlation between asset classes, according to Third Wave chief investment officer Larry Smith.

"A spike in volatility increases risk, but that is offset by the correlation between asset classes which allows the short side of the portfolio to track the long side much more precisely during times of market stress," he says.

"Very little of our risk is market directional. The performance of the portfolio often comes down to, for instance, whether US stocks will outperform UK stocks over a specific period," Smith adds.

Third Wave is also somewhat unique in that it uses a combination of quantitative and discretionary techniques to identify investment opportunities. The quantitative model is based on a pair-wise approach and spans stocks, bonds and currencies. The discretionary side of the portfolio is free roaming and can lead to positions across all the major asset classes.

"Using both quantitative and discretionary techniques means we end up with a better mousetrap. The insights are uncorrelated over time because they come from completely different perspectives," notes Smith.

The quantitative side has historically led to larger bets, but Smith points out the discretionary approach is best for analysing the impact of unusual events like government intervention.

Third Wave is increasing the relative risk of its discretionary trades in light of the dislocations and opportunities created by the political response to the financial crisis, he says.

Irrespective of their investment style, global macro managers see a multitude of opportunities to profit from the dislocations in global markets.

Third Wave has profited from currency trades and long positions in select commodities. But Smith believes some of the biggest opportunities are in the credits markets, which he says have yet to price in the improved outlook for the banking system and the wider economy.

"The probability of a financial Armageddon has receded significantly in the past six months, yet high-yield bond spreads remain above 1,000 basis points (bp)," he points out. The spreads on high-yield bonds have fallen from record highs of around 2,000bp in 2008, but Smith believes there is more to come. "We expect to see high-yield spreads rally to 700bp-800bp. There is a tremendous opportunity in this sector," he declares.

Digging deeper into the credit markets throws up even more compelling trades. Smith says the ABX securities on 2007 mortgages "have been beaten down to absurd levels". He believes the mortgage market is finding its bottom and expects to see these securities rally over the course of the year.

Smith also expects to see a major recovery in long-term swap spreads, which track the yield differential between Treasury bonds and the fixed leg of a floating interest rate swap.

The 30-year swap spread is currently trading below par. Smith attributes this to defined benefit pension schemes, which have been buying 30-year swaps as a hedge against falls in corporate bond yields and long-term interest rates. This caused long-term swap spreads to fall from 80bp in August 2007 to -41bp in November 2008.

"There is no way to justify negative 30-year swap spreads. Since counterparty risk goes up over time, swap spreads should have a positive-shaped yield curve," says Smith. He expects 30-year bond spreads to rally to around 60bp by the end of the year. "We think that is a huge trade."

Carl George, fund manager together with Par Mellstrom of the Pivot Global Value Fund, likes to take a contrarian view. Although the fund pursues opportunities in developed and emerging markets across a wide range of asset classes and financial instruments, George has some strong views on the strategy and where it will be going over the next few months to a year.

The fund philosophy is to take advantage of market misperceptions of risk and of inefficiencies in asset prices brought about by market dislocations or disconnects between asset prices and intrinsic value.

For George, 2008 was a good year for the fund with performance mainly generated from short positions in credit de-leveraging, global economic slowdown and European economic divergence. The portfolio normally comprises four to six uncorrelated themes together with a combination of country, sector and company-specific positions.

He thinks many of the themes that provided performance in 2008 have matured and are less interesting. So the fund is now establishing new positions in sovereign and corporate credits, currencies and equity markets where George believes markets misperceive potential risks and return opportunities.

He expects to continue to develop these and other themes while at the same time looking to exploit prolonged global economic uncertainty that will "continue to throw out tremendous opportunities" during 2009 and 2010.

George thinks the over- and de-leveraging theme has not played through yet and there are still opportunities on the rates and currencies side.

Although over the last two years he has kept the fund net short, George now thinks the balance will shift to long and the fund will probably become more neutral than over the past two years. He sees potential opportunities in distressed assets, high-yield bonds, bid-down equities and one or two currencies where he believes there is scope to go long and make a good return.

Key points on global macro

Tipped to perform well in 2009.

Managers take long and short positions in many markets, predicting and reacting to macro-economic events to make returns.

A strategy that is increasing in popularity.

Well suited to the volatility and uncertainty in the global market as it has a wide mandate, diversification and a liquid nature which allows it to preserve capital. Managers believe these characteristics will ensure continued returns for the strategy.