Following the Federal Reserve's latest decision to increase its benchmark interest rate in March, and as a growing number of central banks around the world reverse their policies of monetary stimulus, advisers and investors should take the opportunity to reassess alternative investment strategies. Global macro funds may be poised for a resurgence as the market cycle shifts from one of calm to increasing uncertainty.
Global macro encompasses a vast array of trades that hedge funds can pursue to take advantage of changing economic and geopolitical policies. Trades can include stocks, bonds, currencies, commodities and derivative instruments. Hedge fund managers often make decisions based on indicators such as interest rates, exchange rates, unemployment, industrial production, foreign trade and liquidity flows in constructing their portfolios.
Returns are often driven by changes in fiscal and monetary policy or market structure derived from a macroeconomic shift. In an environment with a wider dispersion of potential outcomes driven by decentralized economic policies and a changing impact on asset classes globally, macro investors have more opportunities to generate uncorrelated returns with minimal dependency on equity markets.
Many macro funds performed exceptionally well during the last financial crisis. In 2008, as the S&P 500 plummeted 37%, the HFRI Macro (Total) Index rose by 4.83%. In the subsequent bull market — fueled by unprecedented quantitative easing — stocks have easily outpaced global macro funds.
However, available data going back to 1990 show that the HFRI Macro (Total) Index has outperformed the S&P 500 index on an absolute basis with half the level of volatility, far less downside risk and minimal correlation to U.S. equity markets. Historically, macro funds perform best during periods of elevated market uncertainty and increased volatility.
Macro managers can build a portfolio and express their views in a relative value or directional construct. Fixed income and volatility arbitrage are two types of relative value strategies whereby managers seek to exploit discrepancies in the prices of related financial instruments. These strategies become more interesting and potentially profitable as interest rates rise and global asset classes diverge in response to a new macroeconomic paradigm.
Hedge funds frequently construct fixed income arbitrage trades by executing long/short positions between bonds and interest rate swaps, for example. These types of trades are usually driven by a manager's view about changing monetary policies and the corresponding impact of different securities across the yield curve.
Volatility-based strategies typically involve long and short positions between financial instruments and options based on the underlying securities. For instance, a fund manager who believes protectionist tariffs will trigger increasing volatility could construct a position to include the stocks of commodity producers with corresponding options and futures contracts to isolate the price movements between each underlying security. The primary driver of returns is a change in a macroeconomic factor that may not be fully priced in or is underappreciated by the broader investor community.
Some global macro strategies may choose to employ directional trading. For example, a manager may have a view that rising interest rates in the U.S. will put pressure on certain emerging markets. The manager may therefore short the stocks and bonds of that country or use forward contracts to sell its currency, anticipating a decline in the local foreign exchange rate vis-à-vis the U.S. dollar.
SHIFTING MARKET CYCLE
Since December 2015, the Federal Reserve has raised its benchmark rate six times, with additional hikes anticipated to occur in 2018. And in October, the Fed began shrinking its balance sheet in small increments with the goal of getting the total figure to under $2.5 trillion within the next few years.
The UK and Canada recently began hiking rates as well, and central bank officials in the European Union and Japan have started discussing early-stage ideas about curtailing their prolonged near-zero interest rate policies.
Such shifts in monetary policy point to changes in the global economic cycle that traditionally have instigated higher market volatility and investor uncertainty. Ultimately, investors should expect widening credit spreads, greater price divergences among currencies and commodities, and risk assets presenting both long and short profit-generating opportunities as these uncertainties increasingly impact global markets.
Advisers have much to absorb given the rapid evolution in the macroeconomic and geopolitical landscape, such as the potential impact of fiscal stimulus, monetary policy divergence, the prospect of contentious foreign trade negotiations, and threats to regional stability in emerging markets with valuable resources. Historically, such environments have been highly profitable for macro investing. Thus, the question remains: Is the tide finally turning for global macro?
Joseph Burns is a managing director and head of hedge fund due diligence at iCapital Network, a technology platform that simplifies access to alternative investments.