What to Make, and Not Make, of the Recent Performance of Global Macro

What To Make, and Not Make, of the August 2007 Recent Performance of Global Macro

FQ Perspective by Max Darnell

A number of reﬂ ections seem in order given both the investment activity of these last few days and weeks, and given a certain set of erroneous perspectives that we’ve observed. Some of our comments will be correctly read as a defense of our own competitors in the global macro space. While we do not have knowledge of what risks our competitors are taking, we do have solid grounds for challenging certain perspectives that are founded upon the same minimal knowledge that we hold about their products and portfolios. Given that we are doing very well in this market environment we, unlike those who are not doing so well, are in a position to deliver those challenges without ap- pearing to be on the defensive.

7HATSÖ'OINGÖ/NÖ/UTÖ4HERE Ö Let’s begin by taking a distant step back from what we and our competi- One of the most important conse- tors do and consider what’s taking place in the markets broadly. We have quences, as we see it, is that all of this one point to make that we think is being missed, or at least under attended led to the entry of short-term inves- to. To get to that point, we must first frame the issue with the following well tors into less liquid markets. What known facts: qualifies an investor as having a short- term investment horizon? Clearly a Investors have, in recent years, broadly shown a very strong appetite short-term investment objective qual- for return. Some investors such as pension funds have a high need ifies. Hedge funds classically fall into for return to meet their return objectives, while some other inves- this camp. Investors that are either tors have simply developed an appetite for high return after having highly leveraged or with very limited tasted double digit returns in the 1990’s. This appetite is coupled tolerance for disappointing returns with low return expectations and low interest rates. Together, these qualify too. Investors with shorter- have encouraged some investors to use leverage to magnify lower term investment horizons will have expected returns so as to reach desired expected return levels. Add moments of great difficulty when to this mix a glut of liquidity globally which has driven asset prices holding less liquid assets. Forced sell- higher – thus driving future return expectations lower, all of which ing will occur. Asset prices spiraling adds all that much more pressure to take more risk and use more downward and liquidity drying-up are leverage. With realized and option-implied future volatility having held the result. Contrast those investors to low levels for an extended period, some investors have succumbed with endowments and foundations to the pressure to assume volatility will remain low and therefore who have traditionally held less liquid justify taking on more risk than may be appropriate to longer-term assets, but who aren’t forced to run for risk characteristics. the door when the prices of those as- FQ PERSPECTIVE FQ

1 Past performance is no guarantee of future results. Potential for proﬁ t is accompanied by possibility of loss. What To Make, and Not Make, of the Recent Performance of Global Macro

sets weaken because they’re not highly from such strategies is that they’ll de- those dollars. At the fund level, the dol- leveraged and they have a longer-term liver higher than average risk-adjusted lars at risk may very well be the same, investment horizon. returns, and when they do underper- and the scale of returns should not be This entry of short-term players form, their underperformance will tend feared. There are some losses taking into less liquid markets has been, we to be modest relative to the risk they place that merit the drama, but not any expect to find, a very important part of are taking. What is modest underper- such examples exist in the global macro the story unfolding over the last few days formance? That depends upon whether space that we are aware of. and weeks. Was credit, for example, less “insurance” is in place or not – a sub- liquid than it had appeared to be? That ject we’ll come back to below – but appears to have been the case. In de- for strategies that don’t buy insurance )NSURANCEÖ)SÖ&ORÖ4HOSEÖ7ITHÖ fense of others, it was not obvious. The against short-term underperformance, ,IMITEDÖ&INANCIALÖ-EANS liquidity of the credit market that exists modest underperformance means It’s important to be clear about the today had never been tested before be- shortfalls that are equal to or less than difference between products sold as cause it didn’t exist before – not when the risk that is being taken. Modest absolute return and those sold as alpha you take into account the fact that a large underperformance for a fund taking 2% products. Global macro is an alpha prod- share of the participants involved today risk would be 1%-2%, or 7.5%-15% for uct, not an absolute return product. This and the instruments available today are a fund taking 15% risk. simply means that over the long-term, new to that market. If we’re right, more the return to global macro should be risk unwinding should be expected. In largely independent of market returns. the course of that, undervalued assets /BJECTSÖ-AYÖ!PPEARÖ,ARGERÖ The correlation of global macro returns will be sold. 4HANÖ4HEYÖ!RE to the returns on individual asset classes Double digit losses may appear should be low. 7HATÖ4OÖ%XPECTÖ&ROMÖ large, but that’s only due to the mag- Alpha products will experience nification of risk. This is a point that positive and negative returns across the 'LOBALÖ-ACRO our clients know well, but given the profit cycle. They do not insure against Returning closer to home, are the drama created about certain returns losses, and because they do not insure results of some global macro funds in that we’ve seen in the press, it is worth against losses, they are not expected line or out of line with expectations? some emphasis. to deliver positive returns all the time. There are two properties of systematic A 16% loss is not necessarily larger Absolute return products, on the other global macro – the product that we and than a 2% loss. You think I have my hand, should be insuring against losses a number of other very well known math wrong, right? If the annualized if they aim to deliver on their promise firms manage – that make the product risk associated with a 16% loss is 16%, of positive returns all the time. stand out. First, the product, having and if the annualized risk of the product Insurance comes in many forms, but broad access to opportunity across generating 2% losses is 2%, then a 16% they all come at a cost. Buying options is the globe and to multiple asset classes, loss is equivalent to a 2% loss. Invest- expensive, so while buying options can has tremendous breadth. This allows ment returns should always, under all protect a portfolio from certain types of global macro managers to deliver highly circumstances, without exception... be negative outcomes, the negative impact diversified strategies, and that diversi- scaled by the risk they take. on long-term results is quite substantial. fication allows global macro manag- If you’re not 100% convinced, take Dynamic hedging strategies like portfo- ers to deliver higher than normal risk the case of global macro specifically. A lio insurance are also costly. Selling into a adjusted returns. Second, unlike most client that has given us $100m to run at falling market to avoid short-term losses other alpha focused products, there is 10% risk would have risked $10m and typically means locking in recent losses an unusually low correlation amongst earned roughly $7m year to date, while and passing on the opportunity for future the managers themselves. The advan- another client who has given us $1b to gains. We have never seen an approach tages of investing in a diversified basket run at 1% risk would have risked $10m that insures against losses that doesn’t of global macro managers are higher and earned $7m. In other words, a 7% come at a hefty price. than in possibly any other product area return and a 0.7% return are identical For those who have a need to in- except currency where correlations are when adjusted for risk in this example. sure, it is our opinion that they should similarly low. Investors in global macro have moved not pay for insurance at the individual Running highly diversified strate- to higher and higher risk levels in recent asset or fund level by asking their gies does not guarantee positive returns years by investing fewer dollars to the managers to provide guaranteed prod- all the time. What you should expect strategy and raising the risk levels on ucts or to ask their managers to apply FQ PERSPECTIVE FQ 2 What To Make, and Not Make, of the Recent Performance of Global Macro

portfolio management techniques that 4WOÖ6ERYÖ$IFFERENTÖ the markets. That’s not us, and that’s tightly constrain against modest nega- not who most of our direct competitors tive outcomes (insuring against extreme 4YPESÖOFÖ1UANT are either – including those who have outcomes is sensible in certain situa- The news in the press has been underperformed recently. The statisti- tions). Instead, they should focus insur- universally negative about quants. This cal quants are, from what we read and ance, if truly needed, on the net risks in needs to be challenged directly, as there hear, the ones who have really been hurt their portfolio that remain after taking are very different types of quants, and in recent days and weeks. account of the diversification effects of some have done very well in this envi- their individual investments. ronment. Differentiating between them is important. )NÖ3HORT There’s a very big difference be- Diversification is the best insur- $IVERSIFICATIONÖISÖTHEÖ tween learning from the past and as- ance against individual manager un- 0ROTECTIONÖOFÖ#HOICE suming that the future will look like the derperformance, and we know of Diversification is the right alterna- past. Nobody who says that “history no other investment products, other tive to insurance for most investors. repeats itself,” means that in the literal than currency, where the benefits of Combined with a recognition that sense. The future never looks like the manager diversification are greater short-term volatility has little more past. There are forces at work – social, than in global macro. The diversity than an emotional cost in most cases geopolitical, physical, – that will be at of managers in global macro means, (the Pension Protection Act in the US is work in the future in much the same by definition, that one should expect raising at the margin the economic cost way that they have been observed in modest underperformance from some of short-term volatility), investors with the past. of the managers while other managers well diversified portfolios are far bet- It is imperative, therefore, that we are outperforming. One manager’s (or a ter off not paying for insurance at the learn from the past about these mecha- few managers’) difficulties are rarely, in individual investment level, and should nisms, these forces, these relationships, this space, a reason for long-term per- not be trying to avoid, therefore, short- and that we carry these lessons about formance concerns about that manager, term losses that occur at the individual how the world works into the future. We nor are they a reason for concern about investment level. will use what we’ve learned in the past, the category of managers broadly. We Global macro offers nearly unprec- but we will use them to face situations have not lost confidence in our own edented opportunities for diversification, that we’ve never seen in the past. That’s competition! We can’t advise investors and we believe that there are very few precisely what we do at First Quadrant. on this matter, because we don’t have investors who choose to invest in only We use history to study what market the details about competitors holdings, one global macro manager as a result. and economic factors influence market but calm and patience are most likely While some managers have been un- and asset behavior, and we use that to the right choice. derperforming, there are others – like predict outcomes that we may have On the surface it appears that us – who have been enjoying strong never seen before. the institutional quality global macro outperformance. That’s not typical There is another type of quant that managers are in aggregate doing well of investment products, so we’re not does it quite differently, however. There enough, and the press has made far too surprised to see people react with are those who do extrapolate from past too much out of the facts that it has concern when one or more managers to future. Past returns are expected to in hand. We can’t know how this will is underperforming. Most managers in repeat; yesterday’s past winners are unfold short-term, but from our per- individual product categories tend to expected to be tomorrow’s winners. spective, the opportunity set is looking have relatively high correlations with Statistical patterns are expected to richer and richer. We expect our alpha each other, but in global macro, the repeat. These quants are known as hav- to be volatile in the days ahead, but we correlations are much lower. Portfolios ing their focus in the rear view mirror. expect the positive alpha to continue of global macro funds with low correla- Their decisions are said to be led by to accumulate. ♦♦♦ tions are probably doing perfectly fine computers and data, not by their un- right now. derstandings of finance, economics and

This material is for your private information. The views expressed are the views of First Quadrant, L.P. only through this period and are subject to change based on market and other conditions. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. FQ PERSPECTIVE FQ

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