DEMYSTIFYING SYSTEMATIC MACRO HEDGE FUND STRATEGIES Alex N. Kamunya, CAIA Senior Research Consultant, Hedge Funds Introduction: The Case for Systematic Macro proaches that use buy and sell signals based on rules devised from statistical and historical anal- Equity markets, particularly in the United States, yses. They aim to generate returns by taking long have exhibited strong performance since the and short positions in global markets, that is, equi- credit crisis in 2008. As the risk-reward in main- ty indexes, sovereign fixed income, currencies taining an overweight allocation to these markets and commodities. Note that the terms ‘managed diminishes, investors looking to rebalance gains futures’ and ‘commodity trading advisors (CTAs)’ from equities should consider incorporating sys- are often used interchangeably to refer to system- tematic macro strategies as part of their hedge atic macro strategies. fund portfolios. Part of the objective of a hedge fund portfolio is to provide diversification from The paper also explores how systematic macro equities. Systematic macro strategies meet this strategies can add value to an investment portfo- objective. They are an effective and liquid way to lio, and details their potential risks while offering incorporate further diversification into a hedge solutions for their implementation. Overall, we fund portfolio due to their low correlation with believe a diversified portfolio of systematic macro equities. They also tend to perform well in peri- strategies can provide healthy long-term risk- ods of financial market dislocations. For instance, adjusted performance, diversification and down- during the credit crisis, the Barclay CTA Index side protection. While these strategies have ex- recorded gains of 9.5% from September 2008 to hibited tepid performance in the aftermath of the March 2009, compared to losses of 37.6% posted financial crisis in 2008 (we discuss this later), their by the Standard & Poor’s 500 Index (S&P 500) current low valuations may provide an opportune during the same period. time to get in on the ground floor as investors seek to rebalance gains into their hedge fund To be sure, systematic macro strategies can ap- portfolios and diversify away from richly valued pear opaque and complex, discouraging many US equities. investors from a potentially rewarding investment that may benefit their portfolios. While there are Systematic Macro Strategies: An Overview some systematic macro models that are fairly complicated, the most commonly used strategies The evolution and development of systematic the paper focuses on—trend following and coun- macro strategies can be tied to the growth of the ter-trend—are conceptually simple. This paper futures contract, one of the instruments primarily attempts to demystify the underpinnings of these traded to execute systematic macro strategies. A strategies by exploring the fundamental factors futures contract is a standardized contract be- driving their returns. In doing so, we hope to in- tween two parties to buy or sell a specified asset crease investors’ level of comfort with and ability of standardized quantity and quality for a price to analyze these investment strategies. agreed upon today with delivery and payment occurring at a specified future date, that is, the Systematic macro strategies profit from inefficien- delivery date. Farmers began using futures con- cies fueled by long-term macroeconomic cycles tracts in the 1800s to hedge fluctuations in prices and trends as well as the behavioral tendencies of of crops and livestock. Eventually, futures con- market participants. They are model-driven ap- tracts were used by speculators and investors as October 2014 Exhibit 1: Types of Systematic Macro Strategies Technical systematic macro strategies are the largest group. This methodology is based on the theory that price data provides all the Directional necessary information needed to profit from Discretionary market movements. The main types of techni- cally-based systematic strategies include: Relative Value i. Trend following – This is the most com- Global Macro monly utilized systematic macro strategy (Exhibit 2). Its popularity is due to its con- Technical sistent long-term performance, continuity of Systematic returns, ability to trade large amounts of capi- tal, and relatively simple trading rules. In fact, Fundamental up to 80% of the returns generated by sys- tematic macro strategies can be attributed to simple trend following of some form. Trend Source: NEPC following trading models seek to exploit medi- um- and long-term price moves in markets. a vehicle for generating long-term investment re- turns. Trend followers will enter a position once a trend in a market has been established (whether up or The first publicly available systematic macro fund down), expecting that trend to continue. Trend was introduced in 1948 by Richard Donchian. following models are reactionary, that is, they do Many of the techniques he developed, for in- not typically attempt to forecast or anticipate stance, breakouts and moving average crossovers, price movement. These models are designed to are still being used today. However, the growth of react to recent price movements. Trend following systematic macro strategies really started to ac- systems have a low percentage of winning trades celerate in the 1970s and 1980s. This can be (approximately 30% of the trades are successful). attributed to a combination of: However, the profits made in the successful trades are larger than the losses that occur, that a. Rampant inflation in the 1970s, which set the is, they have a high winning trade to losing trade stage for an unprecedented commodities bull ratio (usually at least 2:1). Additionally, trend fol- run that fueled a great opportunity for the lowing systems do not perform well in direction- use of futures contracts. less markets or during market turning points. b. Technological innovation in futures markets, ii. Counter trend – These strategies use which led to the rapid growth of the number methodologies that are the opposite of those and volume of futures contracts traded during used in trend following systems. Counter trend this period, fueling greater liquidity and diver- strategies look to buy and sell oversold and over- sification. bought markets, respectively. Unlike trend follow- In general, systematic macro strategies are classi- ing strategies which do not do well in direction- fied into two broad groups: technical and funda- less markets, counter trend strategies thrive in mental systematic macro strategies (Exhibit 1). trendless markets. They do not do well in trending markets. Additionally, they have a high percent- Exhibit 2: Trend Following Systematic Macro Strategy age of winning trades (approximately 60%) but a Exit when trend reverses Price smaller profit per trade, that is, a low winning trade to losing trade ratio (usually less than 2:1). Profit Enter when Taking Price These attributes result in a low correlation be- price tween trend following and counter trend strate- breaks Case 1 - Trend resistance continues gies. They also tend to focus on shorter time line frames than trend following strategies. As a result, Resistance Line counter trend strategies tend to be capacity con- Case 2 - If trend reverses earlier strained. Cut Loss Limit Source: www.trendfollowing.com 2 Demystifying Systematic Macro Hedge Fund Strategies iii. There are other subsets, such Exhibit 3: Cumulative Performance of Barclay CTA Index vs. Equities (January as strategies that focus on very 1980– June 2014) short-term time frames and/or pattern recognition, which we will not discuss since they are only a small part of the technical system- atic macro strategies offered to- day. Fundamental systematic macro strategies are a much smaller group in terms of number of man- agers that utilize these models. This methodology attempts to ex- amine and understand the under- lying factors driving market price through econometric models that Source: PerTrac analyze a broad set of macroeco- yses of markets and individual securities. Since nomic data. It seeks to develop an understanding systematic macro strategies are model-based, of how fundamentals and markets interact and they tend to be more mysterious and it is not al- bases its positions on that understanding through ways clearly understood how they consistently systematic rules. Typically, these models focus on generate returns. This section of the paper aims value and momentum factors. While the inputs to demystify the underlying factors driving returns for these strategies. SYSTEMATIC MACRO RELIES ON Systematic macro strategies typically rely on the TRENDING AND COUNTER TREND trending and counter trend behavior of markets BEHAVIOR OF MARKETS TO to generate returns. But what causes this market GENERATE RETURNS behavior? Many academic theories have linked the trending and counter trend behavior of mar- used in fundamental systematic mac- Exhibit 4: Average Returns of the Barclay CTA Index, Dow Jones Hedge ro models are different from those in Fund Indices and the MSCI World Index in Periods of Equity Drawdowns* technical models (that is, fundamen- 10.0% 8.9% 7.1% tal versus price data), the drivers of 4.9% return are similar. Momentum factors 5.0% are somewhat similar to those used in 0.0% trend following while value factors -0.6% -1.7% -1.3% -1.2% -1.1% are similar to those used in counter -5.0% -2.7% trend. There are only a few invest- -4.5% ment managers that utilize these -10.0% types of models. However, they com-