Portfolio strategy – Hedge Funds: Macro bets on | Asset class reports

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Key points

  • This could be a good year for the global macro economy due to rising volatility, interest rates and inflation
  • Managers must adopt a more diversified and global vision
  • Relative value strategies should also shine in this current environment
  • Convertible bond and merger funds should benefit from a buoyant market
  • Uncertainty should also provide rich choices for commodity strategies on the long and short side

After years of relative calm, markets are bracing for a much bumpier ride in 2022. Soaring inflation, rising interest rates and continued uncertainty about the direction of COVID-19 are not just a few items on the agenda. However, for some hedge fund strategies, such as global macro, volatility is a perfect backdrop – although managers will need to expand their opportunity set this year.

Macro funds rely on price anomalies, widening spreads and arbitrage opportunities generated by high volatility and turbulent trading conditions in fixed income, currencies and commodities, and sometimes the actions. They’re driven by fundamentals, which is why they haven’t had it easy over the past 10 years.

They thrive on bad news and market shocks, but there have been long fallow periods punctuated by unexpected events such as the financial crisis, the 2018 Italian bond debacle and now the pandemic. They all prompted central banks to pump large sums of money into the markets and keep interest rates low, which dampened bond market volatility and, in turn, hurt the ability macro-managers to generate returns.

Last year, macro hedge funds saw a window of opportunity in the so-called reflation trade. Many are betting that the US Treasury yield curve would steepen as economies emerge from lockdowns. Growth and inflation would pick up and longer-term bonds would sell off, pushing yields higher. Portfolios were positioned to take advantage of the changing landscape but, unexpectedly, there was a rally in US government debt that pushed Treasury yields to multi-month lows.

Losses began to pile up last summer when the Federal Reserve became less optimistic about the transitory nature of inflation and became more hawkish about raising interest rates. As a result, performance for 2021 has been disappointing, according to Kier Boley, co-head of the alternative investment solutions team at UBP. The HFRI Fund Weighted Composite rose 10.3%, but breaking it down, macro discretionary fared the least well, posting a gain of just 2.9% for the year (see figure).

Boley adds, “Macro is the most opportunistic and quickest to adapt to changing economic conditions. They should have had a solid year in terms of relative performance against other hedge fund strategies, but it didn’t.

“They were ahead of the central banks in terms of what was happening with inflation, but when the Federal Reserve got more hawkish and the market went against them, inflation trading at short rates was very crowded.”

Christopher Reeve, Chief Risk Officer at Aspect Capital, agrees, adding: “The economic environment provides the foundation for opportunities to emerge, but managers will need to be good at calling them correctly as it is difficult to predict the timing as well. than the direction of the market. Take last year with the stimulus trade – people were caught off guard in February, June and October.

However, the consensus is that this could be a good year for macro funds, as volatility is here to stay – with inflation and higher interest rates being strong elements in the economy. Heinrich Merz, Head of Hedge Funds at Pictet Alternatives, sums it up for many: “Inflation should be more persistent and now replace the supply chain problem that people were focusing on. Attention has now turned to what central banks will do.

Brooks Ritchey, co-CIO at K2 Advisors, Franklin Templeton’s hedge fund advisory group, also believes monetary policy will tighten and quantitative easing will be withdrawn. “People have become accustomed to low inflation, low interest rates and excess liquidity,” he says. “Our view is that we are going to see an economic transition and an increase in GDP growth, interest rates and market volatility.”

Inflation continues to rise

The pressure is strong for central banks to act. Overall, the Eurozone recorded a record headline inflation figure of 5%.

The UK has just reported levels much higher than expected. At 5.4%, it is the highest rate for 30 years, while in the United States, inflation rose to 7% at the end of 2021.

The Bank of England has already decided to raise interest rates to cool the economy, while the Federal Reserve reversed course in January. After spending most of the pandemic promising to suspend tougher policy so jobs can pick up, he signaled there could be three or four hikes on the horizon for this year.

The European Central Bank, on the other hand, has resisted calls to rein in the economy, while some emerging markets, notably China, are moving in the opposite direction. The country has just cut interest rates to stimulate a slowing economy.

A recent report from K2 Advisors notes that investors are turning to hedge funds to reduce volatility and increase flexibility in their overall portfolio, giving them an option as markets shift to a new regime. Overall, analysts believe assets will shift from fixed income allocation to a diversified portfolio of uncorrelated hedge fund strategies, such as global macro as well as market neutral equities, relative value fixed income, merger arbitrage, convertible bond arbitrage. and CTAs.

Skilled macro managers can particularly benefit from splits in the markets, although if reflation trading is to be relied upon, they will need to be more thoughtful. Merz says: “There is no one size fits all and there will be managers who will succeed and others who will fail. This is a difficult strategy, and they will have to look for other ways to generate returns than the pure steepening curve.

Looking specifically at the global macro economy, Jens Foehrenbach, CIO at Man FRM, believes that on a discretionary level, managers will be able to generate returns through the transition to tighter monetary policy and asset class volatility. assets thanks to rising inflation. It is more conservative on a systematic macro level, as policy changes can be more difficult for systematic managers to predict. In general, however, he recommends underweighting relative value fixed income trades due to the high leverage of these strategies, but he would look at the dispersions between currency and rate spreads in the markets.

From macro to relative value and convertibles

It is also recommended to take a broader global view. Donald Pepper, Co-CEO of Trium Capital says: “It is important to go back to the first principles of diversification and look at the whole universe – both developed and emerging markets – to identify dislocations due to economic instabilities. and policies.

“Our global macro fund is 95% in currencies and rates, and we play the sovereign credit spreads, for example, between Argentina and Brazil, as well as between Mexico and the United States. We want uncorrelated assets, so we largely avoid equities.

Ritchey thinks that relative value long/short opportunities outside of the US are also attractive in developed and emerging market equities. “We believe the dispersion will increase due to a renewed focus on fundamental and macro factor variances,” he adds. “Hedge funds that can capitalize on these differences could generate good returns with a good responsible Sharpe ratio.”

As with other attractive hedge fund strategies in the current environment, convertible arbitrage and merger arbitrage strategies top the list. The first, which consists of a traditional bond that pays a regular coupon and a stock option on the underlying stock, should benefit from robust and continuous issuance.

Performance of hedge fund strategy indices

Schroders research shows that companies are rushing into the market to secure refinancing. Last year there was a record $170 billion (€150 billion) in new convertible issuance and Schroders expects that figure to be around $165 billion for 2022. The Global Universe convertible bonds has now reached around $700 billion.

It’s also attractive “because there aren’t a lot of players in this space,” says Darren Wolf, chief investment officer at Abrdn (formerly Standard Life Aberdeen). “Most of the market is controlled by institutional and retail long-only managers and they wouldn’t consider an equity option on the underlying stock. It’s an interesting strategy, though, because it replicates an option of synthetic selling, which is useful in a market where you expect higher volatility and selling markets.

Regarding merger arbitrage, the strategy should also benefit from a healthy deal pipeline. Not only will there be a bumper crop of traditional bread-and-butter M&As, but there should also be a wave of Special Purpose Acquisition Companies (SPACs) trading at attractive discount prices.

According to Morgan Stanley, markets recorded a record $5.1 billion in global M&A volume in 20201, eclipsing previous records and a dramatic rebound from 2020, despite continued COVID-19 uncertainty. The U.S. bank forecast another record 12-month year on the back of robust economic growth and continued business expansion.

Some also recommend commodity strategies. “The main unknown is the Omicron variant and its subsequent impact on demand in the future, particularly in the energy sector,” according to the K2 report. “This should provide a rich opportunity on both the long and short sides for active commodity traders. A tight supply/demand environment should lead to relative value trading opportunities.

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Don F. Davis