Opportunistic Strategies: Global Macro Strategies

Global macro strategies encompass asset classes and investment instruments, including commodities, currencies, metals, fixed-income, and equities. These strategies aim to identify opportunities by examining global relationships. Global macro managers focus on specific themes, regions, or styles and typically hold views on economic conditions, central bank policies, yield curves, inflation trends, purchasing power parity, and capital flows in various countries.

Global macro managers are often forward-thinking and, at times, contrarian. They may seek to carry gains or ride momentum, but their strength lies in early positioning, profiting when markets return to rational pricing. This anticipatory approach is precious when sudden market reversals are anticipated. For instance, global macro managers foresaw the subprime mortgage crisis in the U.S. as early as 2006. They took long positions in credit default swaps (CDS) on vulnerable mortgage-related assets. Although they had to wait for their CDS positions to pay off, some global macro managers thrived during the global financial crisis, making them a valuable portfolio allocation.

It's important to note that global macro managers trade diverse instruments and use various methods, making them heterogeneous. Consequently, they don't consistently provide short alpha like pure systematic trend-following managed futures funds. However, their anticipatory approach can be a valuable attribute.

Investment Characteristics

Global macro managers employ fundamental and technical analyses and apply discretionary and systematic implementation methods to assess market values. Depending on economic trends and specific themes, their views can be directional or thematic.

Leverage, often gained through derivatives, is common among global macro managers, allowing them to magnify potential profits. Leverage can be as high as 6 to 7 times a fund's assets, which enhances flexibility in relative value and directional positioning.

Global macro strategies primarily rely on identifying and capitalizing on market trends. They thrive during periods of market turbulence, such as steep equity sell-offs, shifts in interest rates, currency devaluations, volatility spikes, or geopolitical shocks. However, macro managers may experience uneven returns due to unforeseen factors or unmaterialized risks, leading to comparatively higher volatility.

The quantitative easing era following the 2007-2009 global financial crisis created less favorable market conditions for global macro managers. Low volatility across various markets and central bank interventions limited their opportunities. Some allocators began avoiding these strategies, but doing so may overlook their usefulness over a complete market cycle, offering portfolio diversification and alpha generation.

Strategy Implementation

A top-down approach characterizes global macro strategies and relies on various macroeconomic and fundamental models to express views on the direction or relative value of assets or asset classes. These strategies encompass positions in individual securities, baskets of securities, index and foreign exchange futures, precious and base metals futures, agricultural futures, fixed-income products or futures, and derivatives or options.

When making directional bets, managers use fundamental data to determine whether a market or asset is undervalued or overvalued compared to historical trends and expected macroeconomic developments. In contrast, managers focusing on relative value consider the relative valuations of assets in light of historical and expected macro conditions.

For instance, if the currencies of major ASEAN countries are depreciating against the U.S. dollar, a directional model might suggest purchasing shares of key exporting companies. However, further analysis may reveal that the public bonds of these exporters are undervalued relative to their shares, leading to a strategy of buying bonds and shorting shares. This scenario is likely when share prices react quickly to currency depreciation while bond prices take longer to respond.

Successful global macro trading necessitates a correct fundamental view of selected markets and effective methods and timing to express tactical views. Managers who repeatedly implement positions too early, unwind them too late, or choose inappropriate implementation methods risk investor redemptions. Given the inherent leverage in global macro strategies, managers may be tempted to carry numerous positions concurrently. However, the diversification benefits are typically less pronounced compared to more idiosyncratic long/short equity strategies, primarily due to the impact of “risk-on” or “risk-off” market conditions, often influenced by central bank policies, which affect various asset classes in a correlated manner.

Opportunistic Strategies: Managed Futures

Investment Characteristics

Managed futures represent an asset class that doesn't follow the same patterns as stocks and bonds, making them valuable for traditional portfolios. They can enhance the risk-adjusted returns and diversification of a portfolio. During challenging market periods, like the 2007-2009 financial crisis, managed futures demonstrated their worth. Managers profited by taking short positions in equity futures and long positions in fixed-income futures when traditional assets like stocks and bonds were experiencing significant fluctuations.

One of the advantages of managed futures is their natural positive skewness. This characteristic complements negatively-skewed investment strategies, providing a counterbalance that can be advantageous in various market conditions.

However, the return profile of managed futures is cyclical and depends on market conditions. Between 2011 and 2018, market trends in foreign exchange and fixed-income markets deteriorated, while volatility levels decreased, impacting managed futures performance. In this context, the diversification benefit of trend-following strong equity markets is less pronounced.

Furthermore, managed futures' correlation benefits have evolved in a low-yield environment where sovereign bonds approach zero yields. The practice of trend-following in fixed-income markets as yields rise may not be as effective in the future. Instead, if managers trend-follow as yields fall (i.e., as interest rates normalize), they may still achieve positive returns but with different correlation behavior to equity markets. Additionally, the upward-sloping nature of global yield curves may result in less natural fixed-income “carry” contribution from trend-following as rates increase and prices decrease.

Managed futures are known for their high liquidity, active trading across various asset classes, and the ability to go long or short quickly. The liquidity stems from the highly active futures markets, which often exceed the trading volumes of traditional equity markets. These markets offer liquid exposure to various asset classes and are accessible 24 hours a day globally. Futures contracts demand relatively modest collateral due to central clearinghouse management of margin and risk, allowing for higher leverage than traditional instruments.

For example, futures contracts require a margin ranging from 0.1% to 10% of the notional value for both long and short positions, in contrast to standard equity market margins in the United States, which typically stand at 50%. This capital efficiency enables managed futures managers to be dynamic in their long and short exposures. In a managed futures account, most of the capital (usually 85% to 90%) is invested in short-term government debt or other highly liquid collateral accepted by the futures clearinghouse. The remainder (10% to 15%) is used to collateralize long and short-term futures contracts.

Strategy Implementation

Managed futures funds benefit from the flexibility of highly liquid contracts, allowing them to employ various investment strategies. Most managed futures strategies rely on pattern recognition triggers, which are either momentum-driven or based on volatility signals. Managers implement these signals across different timeframes, often incorporating short-term mean reversion filters alongside their core longer-term models.

For example, a manager might initially establish a short position in gold futures based on a long-term model indicating a downward trend triggered by crossing a short-term moving average below a longer-term moving average. Later, the manager may introduce a shorter timeframe model suggesting that the downward momentum in gold prices has temporarily slowed, indicating a mean-reverting bounce. The results from both models are weighted and combined into an adjusted net position, typically giving more weight to the longer-term model.

Managed futures managers often incorporate fundamental factors such as carry relationships and volatility into their core momentum and breakout signal methodologies. These factors aid in determining position sizes, with the greater volatility of an asset resulting in smaller portfolio sizing and stronger correlation with other futures leading to smaller portfolio sizing as well. Analyzing the correlation between different futures contracts becomes an essential risk constraint in portfolio sizing.

In addition to core position sizing and adjustments for volatility and correlation, managed futures managers employ various exit methodologies, including price target exits, momentum reversal exits, time-based exits, trailing stop-loss exits, or combinations. Maintaining a consistent approach and avoiding overfitting models during performance backtesting is crucial to ensure that models perform well in future “out-of-sample” periods.

Managed futures strategies often utilize time-series momentum (TSM) trend following, a common approach that relies on the past returns of individual assets to make trading decisions. Managers typically go long on assets with rising prices and short on assets with falling prices. TSM strategies are traded on an absolute basis, meaning that the manager can be either net long or net short, depending on the current price trend of an asset. These strategies are most effective when an asset's past returns reliably predict its future returns.

Cross-sectional momentum (CSM) strategies involve selecting a subset of assets within an asset class and taking long positions in those with the most substantial price increases while shorting those with the most significant price declines. These strategies typically maintain a net-zero or market-neutral position. CSM strategies are effective when a market's relative outperformance or underperformance compared to others reliably predicts its future performance. However, CSM strategies may face limitations due to the availability of futures contracts for a cross-section of asset class-level assets.

Both global macro and managed futures strategies often trade similar markets but employ different approaches. It's essential to recognize the distinct characteristics of these two strategies.

Risk Profile and Liquidity

• Both global macro and managed futures strategies are highly liquid but may experience crowding and execution slippage issues in managed futures due to rapid growth in assets under management (AUM). Global macro strategies, being more diverse in their approaches, are less affected by execution crowding.
• Managed futures managers typically follow a more systematic approach, while global macro managers tend to use more discretion when applying models and tools.
• Managed futures strategies usually show positive right-tail skewness during market stress, making them valuable for portfolio diversification. Global macro strategies also provide diversification but with more varied results.
• Despite positive skewness, managed futures and global macro managers are somewhat cyclical and have higher volatility, significantly when the strategy's time horizon is extended. Additionally, macro managers may act prematurely and overly anticipate their positioning.

Leverage Usage

• Futures contracts inherently offer high leverage, enabling control of notional amounts far exceeding fund assets, typically 6 to 7 times, with initial margin-to-equity ratios as low as 10% to 20%. Global macro managers often enhance this leverage by actively using options, which introduce additional leverage and positive convexity elements.

Benchmarking

• To effectively monitor performance, managed futures strategies can be assessed using sub-indexes like HFRX, HFRI Macro Systematic Indices, CISDM CTA Equal-Weighted Index, Lipper TASS Managed Futures Index, and Credit Suisse Managed Futures Index. Meanwhile, global macro strategies are best evaluated using HFRX and HFRI Macro Discretionary Indices, CISDM Hedge Fund Global Macro Index, Lipper TASS Global Macro Index, and Credit Suisse Global Macro Index.

Question

Describe the operational mechanics of the CSM and TSM strategies and assess their respective risk profiles.

1. CSM and TSM employ different methods for asset selection and allocation.
2. CSM and TSM share common risk factors but differ in their implementation.
3. CSM focuses on fundamental analysis, while TSM relies on technical indicators.

Solution

The correct answer is A.

It highlights that the two strategies have different operational mechanics, specifically regarding selecting and allocating assets. This addresses the first part of the question by explaining their operational mechanics.

B is incorrect. It partially addresses the risk profiles but doesn't sufficiently explain their operational mechanics, which is the first part of the question.

C is incorrect. While this answer provides some information about their approaches, it does not sufficiently describe the operational mechanics of the strategies.

Reading 38: Hedge Fund Strategies

LOS 38 (e) Discuss investment characteristics, strategy implementation, and role in a portfolio of opportunistic hedge fund strategies.