George Soros bets against the British pound and makes $1.5 billion in one month.
That 1992 trade catapulted Soros to superstar status in the hedge fund world and is probably the most famous example of global macro strategy at work.
The approach has come a long way since. In fact, there are almost as many variants of the strategy as there are managers using it. But they all have one thing in common, notes Jamison McAuley, vice-president, Investments at Inflection Management Inc. in Vancouver: “In macro land, they have the authority to do whatever they want, anywhere in the world.”
Big bets, big fortunes
Though in many ways eclipsed by new approaches, discretionary global macro strategies run by Soros-type figures are still alive. “They’ve got a reputation for making huge fortunes for people, but [they’re] extremely uneven,” says Ari Shiff, president and chief strategist at Inflection Management in Vancouver. Often the manager will make a large sum in a single year, then go multiple years in the red before hitting another win. “It tends to be high volatility.”
To get access to these managers, clients either need to put up millions or buy into a fund of hedge funds that has exposure. Shiff, who manages a fund of hedge funds, has gone cool on this method.
He prefers managers whose bets are based on mathematical models. “The mathematical style has a lot less ego in it. There’s so much complexity in global macro that it just seems to work better when it’s heavily governed by mathematical models.”
Shiff adds that even when Soros-style managers are right, it may take years to get the payoff. That’s because they may have made a correct call, but the market may not be reacting in the direction they need it to. “So they tend to dig in their heels and say, ‘I’m right and I’ll wait it out.’ This is fine if you’re taking a long view, say, 10 years. But as a fund of funds we have to produce strong returns on an annual basis, so we simply can’t wait out some of these large structural bets.”
McAuley notes the multi-manager approach more effectively diversifies risk. The fund will have as many as 30 managers working independently, “so the portfolio, when it’s aggregated up, becomes a low-risk, low-volatility, low-correlation portfolio.” In some shops using this style, managers get more or less of the fund’s assets based on performance. “It’s pretty cutthroat. Some funds we work with have drawdown limits. If you’re down 5%, they cut your book in half; if you’re down another 5%, you’re out.”
McAuley notes some of the big-personality managers have opened separate multi-manager and quantitative platforms. For example, billionaire headline-maker Paul Tudor Jones’ group, Tudor Investment Corporation, has both the discretionary global macro strategy run by Paul Tudor Jones himself and separate quantitative offerings, among others. (Tudor Investment Corporation declined to comment for this article.)
Global macro, low-vol style
Do the big thematic bets of the world’s George Soroses make you and your clients nervous? There’s a much less risky way of doing global macro.
Luca Simoncelli, a senior portfolio manager with Unigestion’s Cross Asset Solutions Team in London, U.K., targets cash plus 4% with less than half the volatility of equity indices. The approach has three main pillars.
1. Strategic asset allocation
This is the backbone of the strategy, providing much of its stability. It’s devised with a three- to five-year horizon. The first component involves identifying four economic regimes:
- Steady growth: Economic growth that is at or above potential; inflation is under control.
- Inflation surprise: Negative feedback in the market caused by an inflation spike.
- Market stress: Investor sentiment has a negative impact on financial markets.
- Recession: Negative economic growth.
Each regime is linked to a distinct basket of investments, and each basket is designed to provide the exposure that performs best under its linked regime. The portfolio’s baseline strategic allocation is: 60% to the steady growth basket, 10% to market stress, 15% to inflation surprise, and 15% to recession. These weights are tweaked depending on which regime is currently in play (more on this later).
The content of the baskets is drawn from this universe of risk premia:
Traditional risk premia
- Government bonds
- Inflation-linked bonds
- Credit. Risk-based allocation to credit default swap indices across credit ratings and geographical zones (Europe, North America and emerging markets)
- Developed market equities. Combination of index futures and in-house risk-based selection process. Equity factors are value, quality, momentum and size
- Emerging market equities. Combination of index futures and in-house, risk-based selection process
- Commodities. Energy, precious and industrial metals (exchange-traded)
- Foreign exchange. Full scope of developed and emerging market currencies
Alternative risk premia
- Trend following. Mainly systematic in approach; covers bonds, equities, credit and foreign exchange.
- Carry strategy. Systematic strategy applied to bonds, equity, credit, volatility and foreign exchange.
The composition of the four baskets is as follows:
- Steady growth: Developed market equities, emerging market equities, credit, and carry strategy
- Inflation surprise: Inflation-linked bonds, precious and industrial metals, energy and trend-following strategy.
- Market stress: Government bonds, precious metals and trend-following strategy.
- Recession: Government bonds and trend-following strategy.
2. Dynamic asset allocation
This involves tweaking the strategic allocation based on fundamentals, valuations and sentiment. The time horizon for these moves is six to 18 months.
Currently, the overall allocation is biased toward the steady growth basket, Simoncelli notes. The weightings are: 80% steady growth, 7% market stress, 5% inflation surprise, 9% recession.
Simoncelli uses a model that provides a real-time indication of how economies are performing. “Think of the GDP number that comes out once a quarter [based on historical information]. Once you get the number, it’s too late,” he notes. So, every week, he gets his model to indicate where we are in the cycle; the model also shows whether any growth has momentum or is decelerating. The number it generates is an aggregation of multiple indicators, including housing data, durable goods consumption, production expectations and employment.
He adjusts the strategic allocation mainly through index futures.
This is a separate part of the portfolio that focuses on alpha generation over a short time horizon: from days to a maximum of three months.
Simoncelli and the other senior portfolio managers try to exploit tactical ideas that avoid directional bets. They’re all relative value (pair) trades, such as:
- long U.S. financial sector equities, short the broader S&P500
- long Mexican bonds, short U.S. Treasurys
- put options on U.S. Treasury futures
Global macro for 60/40 clients
Alternative investments have a place in the portfolios of balanced, 60/40-type clients, and exposure to global macro is a must for that alternative allocation, says Lowell Yura, head of Multi-Asset Solutions at BMO Global Asset Management in Chicago. He runs an alternatives fund of funds, giving global macro about a 20% allocation. To get into his fund, managers have to spread their risk across a variety of areas.
“They’re going to be wrong [on some bets], and you don’t want one wrong view to dominate the portfolio.”
Managers are making calls on fixed-income and equity markets, currencies, interest rates, commodities and more. Calls are either directional or relative. Directional bets make a call (long or short) on a single area—e.g., equities—and can be implemented by buying physical equities or, in many cases, using derivatives. Relative bets are often pairs. Yura gives an example: “If you think European equities will do better than U.S. equities regardless of what direction they take, you would go long European equities and short U.S. equities.”
He adds: “A big trade over the last year has been long U.S. dollar, short euro because Europe’s recovery is so far behind [that of] the U.S.”
Pairs in global macro funds can work similarly to those used by market neutral fund managers (see “Play it safe with market-neutral strategies”). The vehicle and research process may be different, but the logic of the trade is the same: provided the long position goes up more or down less than the short, the manager’s bet pays off.
Directional bets aren’t exactly a deal breaker for Yura, but he likes to see more pair trading because it’s less volatile. Most funds he considers are looking for volatility below 6% or 7%. “If you’ve built the portfolio with a lot of directional views, you’re going to exceed that risk budget
Best of both worlds
Talk to enough mutual fund managers and you’ll find many make a point of ignoring macro. It’s all bottom-up, all the time. If that strikes you as incomplete, you’re not alone. One approach to global macro is to marry the benefits of top-down and bottom-up analysis.
Jay Bala, portfolio manager at AIP Asset Management in Toronto, begins with top-down analysis: Which geographies are showing strength, and which are showing weakness on a macro level? Once he identifies the countries with the best three- to six-month outlook, he zeroes in on the sectors within those geographies that appear poised for the strongest performance. The final step: picking the best companies within those sectors. That’s where the bottom-up piece comes in.
He wants to see companies meeting or exceeding expectations. “Where we roll out of a position is if a company has been [meeting expectations] for, say, 10 straight quarters, then all of a sudden the last two or three they miss them. That’s our signal.”
Currently, he’s heavily focused on the U.S. A key exposure on the sector-level is tech: large companies that are cash-flow positive are in; those that aren’t are out. Overall, he targets about 45% in dividend-paying blue-chip stocks and 45% in investment grade bonds.
When he likes emerging markets, he tends to avoid direct exposure. For instance, if he thinks Malaysia is going to do well, he would look for large companies domiciled in Europe, North America or Japan that have operations in Malaysia. Because of the better regulatory and legal environment in developed markets, “we can actually trust the numbers.”
Ten percent of the portfolio is what Bala calls the “special situations pocket.” The goal, he says, is to put alpha-generation into overdrive via distressed debt, privately negotiated loans and convertibles. “Where it takes two to three days for due diligence on a stock position, it could take four to six weeks for a special sits deal.”
Say he’s interested in loaning money to an oil and gas company. “We would send down an external auditor, and they would go through all the books, records and bank accounts, making sure all the cash that came in landed where it’s supposed to. Then we would send out a petroleum engineer to make sure all the wells are in order.” If he decides to go through with the loan, he would configure the deal in one of two ways. “We convert either into equity or actual physical barrels of oil. [As lenders], we’re senior on the stack—first rank on all the assets. In the worst case, we’re getting most of our principal back.”
Overall, Bala shoots for about a 1% to 1.5% return per month.