18 February 2020
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Insights from Global Macro guys...

Christopher Joye
22 February 2011

Some time ago I read two excellent studies by the well-known hedge fund advisor, Steven Drobny: The Invisible Hands and Inside the House of Money. Drobny presents some outstanding, although mostly anonymous, interviews with leading 'global macro' hedge fund managers (that is, of the George Soros ilk) who have generated strongly positive returns both prior to, during and post the crisis. I have excerpted the quotes below that I found interesting. I have also included one of Drobny's charts and a table that quantify the long-term numbers on how this strategy stacks up against other styles.

For a larger image, click here.

1. Interest rates are the purest possible global macro trade

This is a perceptive summary from an anonymous currency fund manager in London:

“To me, foreign exchange is not a true macro strategy. It's the tail of the distribution. There is only one true macro trade and that's the price of money. Everything else is a function of the price of money. Central banks control the price of money and drive everything with their central bank rate. They use monetary policy to get supply and demand moving in the economy by encouraging people to move out along the risk curve. The risk curve, in essence, is the credit curve. Of course, fiscal policy is controlled by government, so we also keep that variable in mind when looking at the current and future prices of the assets we trade ... Foreign exchange is like the fan at the end of the credit curve. It's a function of how people are looking at those credits along the curve ... [Currencies] are beta on interest rate and credit sentiment, or beta on beta. Foreign exchange is sentiment driven because it's a relative price between two countries. It reflects the relative sentiment of investors, reality and the perception of a bunch of different factors between two economies.”

2. The uniquely 'Sorosian' approach to risk-taking

I had read this somewhere else before, but it is still a classic. It's from Stan Druckenmiller, the billionaire who ran George Soros's hedge fund for a long time:

“Soros has taught me that when you have a tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you're right on something, you can't own enough.”

3. Markets are a game, and mostly a good one...

One very bright Swedish macro guy had some pretty profound remarks to make on markets, psychology, risk, return, and pricing:

“Markets are an intense, intellectual game with real consequences and, when properly done, with real benefits both for the risk takers and society. I find markets fascinating, particularly the macro elements because of the interplay between the international economy and geopolitics...

It is much more difficult to understand your own psychology than the markets' psychology. It takes a much longer time to truly understand how you work, how you function psychologically in various environments, and how you manage this psychology and your risk as you monitor the markets...

Many investors rely on basic rules of thumb rather than reasoning and analysis built on sound financial theory. Many assumptions are made without any regard to whether they have any logical backing or not. A good example would be the assumption that equities always generate good long-term returns, regardless of the price at which you buy them. This is total baloney...

Many people think the expected return of an asset is determined by its risk. That is getting it the wrong way around. The right way to look at it is: the expected return is a function of the risk premium of the asset at a given price. This is different than saying return is a function of risk ... A risky asset priced with a small risk premium is just a bad investment...

Saying that equities or other risky assets will always deliver high returns in the long term is just incorrect. Price matters. Valuation matters...

Alpha is in a strict sense a zero sum game, although with beneficial externalities for society.”

4. Global macro is agnostic to market direction

The unnamed 'philosopher' had this to say on a bunch of interesting stuff:

“Global macro is agnostic to market direction; you just want things to happen. Many other investing strategies, however, are essentially bull market strategies, performing better when markets go up and volatility is low and declining...

The macro stream to which I refer is comprised of things that are different than beta or beta-plus. For example, discerning what country will hike first has no relation to beta, and it is not even tactically trading beta. Rather, it has to do with global economics, and central bank reaction functions. It has nothing to do with beta...

Policy activity is one of our bread-and-butter sources of returns ... [But] I do not think that I could become a central banker. I am temperamentally suited to say what I think, and it is very difficult for policy makers to say what they think...

I run a macro fund, and I reserve the right to be wrong ... I get things wrong, change my mind, and move on. Central bankers are not allowed to do that--it is very hard for a central banker to say, “That rate cut last year was a mistake”…

The uncertain nature of the economic future and our flawed attempts to understand it are a permanent source of market mispricing. The economy is not easily predictable, but the reactions of policy makers and the persistent errors in human expectations are...

We have a hit ratio of around 50 per cent ... If you have a hit ratio of 50 per cent and an average payoff of 3:1, then you make a lot of money. Perhaps surprisingly, I actually find that it is helpful to be wrong half the time. Stopping out of a trade is psychologically much easier when you reserve the right to be wrong half the time.”

5. Uncertainty and volatility can be sources of alpha

I have written at length about how we should expect much more volatility in the future, especially given our leverage to China/India. Here's what one of the top hedgies says about this in a post-GFC world:

“The point is that governments, monetary authorities, and noneconomic agents matter again, and these agents will provide much more alpha to markets going forward than they have for years. When you have volatility in times of flux, you have increased probability of a policy error, and that is one of the greatest sources of alpha for macro managers.”

6. A macro guy in 2004, years before the GFC

“My gut feeling is that there will be a lot of pain because we still have to pay for the 1990s and that worries me. It worries me on a personal level and a family level, but on a business level, it's fantastic. It's the dichotomy of this business that we thrive on dislocation and economic upsets. Macro traders always do better when the world economy is tanking. It's a great hedge, in a way.”

7. Changing the way you set monetary policy creates volatility and opportunity

I have written about the fragility of central banking credibility (witness what is happening with the Bank of England today, which is semi-extraordinary), and how the inflation-targeting regime used by the RBA is largely untested. I have also written about how evolving the conduct of monetary policy to account for credit growth and asset prices will create a much more uncertain environment. The manager in (4) above had similar sentiments:

“You could argue that inflation targeting has worked as planned, but that it also led to the crisis of 2008. Because people thought that price stability was here forever, they started levering up, and asset prices exploded. An example where alpha may result from policy change going forward is central banks moving away from inflation targeting, whereby they perhaps target inflation and credit growth. That would generate volatility and change how risk premia are valued. Another source of alpha from policy makers is when there is some kind of regime in place that is at odds with valuation, whether it is a managed exchange rate regime, or artificially low rates. These regimes tend to work until the world changes. During structural breaks and regime shifts, financial markets tend to lag the real economy, generating opportunities for macro investors.”

8. China is a major manufacturer of market risk and uncertainty

As noted above, I have written about how China/India are likely to amplify Australian economic volatility in a major way. The RBA likes this narrative too. Here is what one overseas hedge fund thinks on the subject:

“From an inflationary standpoint, China is the cornerstone of this thesis. China will create more boom-bust cycles in commodities than we have had in the past because the volatility of their growth and output is so much higher than that of the developed world. Furthermore, their motives for economic output do not necessarily have profit as the cornerstone. That will create more volatility in both commodity markets and broader financial markets going forward.”

9. Why the front-end of the interest rate curve is the best place to be (and other pearls)

Dr John Porter, who runs all discretionary risk at Barclays Capital, offered up these insights years prior to the GFC:

“Concentrating risk in the front end of the yield curve, the only thing that can really make me right or wrong is a central bank. A central bank has the ability to enhance or diminish my carry, and we want carry. Everything else is just noise...

All I am trying to do is arbitrage between what a central bank is going to do and what the market thinks it's going to do. I like to know what traders are doing, but that's not really relevant...

Relative value hedge funds and hedge funds in general are all about leveraged selling of volatility. We do the opposite ... My strategy is to try to take advantage of market distress to lock in as much carry as I can. Most of the time, I'm not going to be invested, and there's not going to be any return, but I will make significant returns at the moment of distress by taking the other side...

The most important variable to me and my trading is the probability that a central bank will move interest rates in line with the market. That's where I focus my macro calls. It provides a decent anchor because it's something I can truly get ahold of as opposed to trying to understand supply, demand, or some other micro variable to the macro story...

Unless I can see compelling reasons why a position should be diversified, I believe you're fooling yourself if you have a lot of positions on. The more positions, the more potential for losses. If there's an instrument that you think will capture 80 to 90 percent of your thesis, why distract yourself with a bunch of positions?”

For a larger image, click here.

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