Global Macro & CTA Outlook For 2014 Is A Mixed Bag According To NB

By Neuberger Berman Alternative Investment Management

Introduction

Macro-focused investing is broadly defined as profiting from changes in market prices that arise from any number of factors, including turning points in macroeconomic cycles, changes in the outlook for economic growth or inflation and market price reactions stemming from the actions of policymakers.

In Figure 2.1, we segment the Global Macro strategy into three broad categories: Discretionary, Systematic and Commodity Trading Advisor (CTA)/Managed Futures, with more granular sub-strategies underneath each.

Discretionary Macro

These managers execute their strategies by establishing directional positions at the asset class level to express a positive or negative top-down view on a market. Of all of the hedge fund strategies, discretionary macro affords the manager the most flexibility, with managers able to express either long or short views, across any asset class, in any region, globally. Some discretionary macro managers may focus on a more narrow set of asset classes or on a specific geographic region.

Systematic Macro

The systematic macro strategy is something of a hybrid between discretionary macro and CTA/managed futures. Most often, the signals that the manager uses to enter into positions are based upon an analysis of fundamental data, similar to the discretionary macro funds, but the determination of those trades is based on a systematic, or model-driven process, as is the case with CTAs.

CTA/Managed Futures

The instruments that CTAs trade tend to be very similar to those that discretionary macro managers trade. However, the manner in which they arrive at those long or short positions could not be any more different. The vast majority of the CTA universe applies priced-based trend-following algorithms to the trading of equity index, fixed income, currency and commodities futures contracts.

All three of these sub-strategies can be correlated, or they can exhibit wildly different behavior depending upon the environment. As we begin 2014, we believe that the latter outcome is more likely, and our view is that discretionary macro funds are the best-positioned macro sub-strategy. We are less constructive on CTAs.

It is not a controversial statement to say that we have been living in a policy-driven world since the global financial crisis in 2008. Since that time, central banks have employed various forms of monetary easing, first in the U.S., then in Europe and Asia. Five years later, with the U.S. leading the recovery in developed nations, policymakers are now searching for ways to draw the largest quantitative easing program in history to a close. Their actions will continue to have implications for the success of various Global Macro strategies and will continue to present fertile trading opportunities for select sub-strategies.

In addition, we believe that consideration of a discretionary macro strategy is timely, given the reduction of global proprietary trading desks spurred by the Volcker Rule. Many talented traders have launched their own funds. In the remainder of the article we explain the rationale for our view in more detail.

Have CTAs Lost their Touch?

Historically, performance and lack of correlation to credit and equity markets have made CTAs popular. There are several types of CTA strategies, including trend-following, mean reversion and pattern recognition. The vast majority of managed futures assets under management (greater than 85%, by our estimates) are trend followers; we are currently bearish on this class of CTAs.

Trend followers do not actively predict the direction of markets, but instead respond to changes in market prices. If the changes do not turn into a persistent trend or if the prevailing trend reverses direction, the algorithm will incur losses. Typically after initiating a trade, the algorithm will instruct a sell (or a cover for a short position) if losses exceed predefined limits. As such, trend followers perform poorly when markets trade sideways and when trends are frequently interrupted by factors such as government policy or intervention that can result in sharp turns in markets—precisely the type of environment we have been in since quantitative easing was initiated. And while we are starting to see signs of easing in certain markets, this process will likely take years to fully complete.

The deficiency in performance since the global financial crisis has been supported by empirical data on CTA returns. In Figure 2.2, we can see that the annual returns of three commonly referenced CTA indices, the Barclays CTA Index, the HFRX Macro-Systematic Diversified CTA Index and the Newedge CTA Index have been muted since 2009. Even when taking positive performance in 2008 into consideration, the indices’ cumulative returns from 2008 to October 2013 are lower than that of the S&P 500 Index and the Merrill Lynch Fixed Income Index.

Besides overall performance, the other key benefit of investing in CTAs has been their low-to-negative correlations to equity and credit markets. Particularly over the last decade, CTA returns have been flat or positive in difficult months for the broader markets. However, upon closer examination, a significant factor driving this return pattern was large gains due to net long positions in fixed income. The 30-year bull market in U.S. Treasuries since 1980 has been one of
the more prominent trends in tradeable markets. Despite this, we believe developed nations are more likely to experience a secular period of rising rates going forward (witness the yield on the U.S. 10-Year Treasury backing up from 1.6% in May 2013 to 3.0% by the end of 2013, as well as the recent start of tapering by the Federal Reserve).

In fact, many CTAs have already made the adjustment from being long to short government bonds. Regardless of this recent change in positioning which may be temporal, we believe that over the next several years, CTAs are more likely to be net short government bonds than to be net long government bonds. With that positioning, and when a pickup in market volatility leads to a flight to quality, CTAs may no longer be negatively correlated to traditional asset classes. As
such, CTAs may not necessarily provide the same diversification benefits on a consistent basis going forward.

In Figure 2.3, we can see that on a three-year and five-year basis, CTAs have underperformed most asset classes. On a 10-year basis, CTAs have generated sizable returns, but that pales in comparison to longer-dated Treasuries, where we believe they held long positions for a significant part of the past 10 years.

On the subject of fees, many investors believe that hedge fund fees have historically been too high. For CTAs in particular, 63 managed futures funds that reported to the SEC generated $11.5 billion of gains between January 1, 2003 and December 31, 2012; 89% of that went to fees, commissions and expenses ¹. Perhaps as a result of such observations and criticism from investors, a number of CTAs have moved to launch lower-fee versions of their trend-following strategies, a development we applaud. While the lower-fee vehicles may fare better than their full-fee cousins, we still believe that the current macro environment will continue to present challenges for the strategy.

On the other hand, we believe that discretionary global macro managers are better suited to generate profits in the current policy-driven market environment. Also, because their playbook is much broader than that of CTAs, they should be better positioned to exploit a wider variety of opportunities. Macro managers use several trading strategies that we believe have the potential to generate returns in the current market:

1. Momentum: Predicting the direction of an asset class and taking long or short positions to generate returns while that momentum lasts. This is similar to a CTA trend-following strategy, but the macro manager overlays more discretion as to which trends to follow and can actively risk-manage positions to seek to avoid losses from trend reversals. CTAs, on the other hand, tend to be purely systematic and are therefore less able to assess the increasingly important qualitative context and market positioning around potential trades.

2. Carry (or anti-carry): These include borrowing from a low interest rate currency to fund the purchase of high yielding currencies or assets. Managers can find similar trades in the fixed income and commodities markets as well.

3. Relative Value: The manager sets up trades to profit from the normalization of related currency, commodity, equity and/or fixed income securities, which often trade at spreads to each other that can fluctuate due to short-term news, events or technical factors.

4. Mean Reversion: Identifying dislocations across markets based on top-down fundamental analysis and asset class valuation.

At a more granular level, we currently observe a wide array of thematic opportunities that discretionary macro funds can attempt to exploit. These themes have and will continue to spawn trading opportunities across all four of the strategy types listed above. While these themes will lead to directional price action, that price action will likely not occur in a straight line, thus emphasizing an approach that can remain dynamic, nimble and flexible in the face of a changing opportunity set.

1. Fed tapering in the U.S.: The implications of the Federal Reserve withdrawing $85 billion a month of bond buying could lead to opportunities in the fixed income and currency markets.

2. Timing and magnitude of eventual Federal Funds rate hikes: It is commonly accepted that a Fed Funds rate tightening cycle is on the horizon. The timing and magnitude are subject to intense debate and are creating trading opportunities in the forward rates space within the fixed income market.

3. Deficit reduction: The mandate to reduce deficits across developed economies is leading to opportunities in the interest rate markets, due in part to the supply of government debt outstanding.

4. Commodities: The commodities markets were among the worst-performing asset classes in 2013. Each individual market is subject to its own particular fundamental and technical value drivers, but if the modest pickup in global growth continues, these markets may be due for a change in direction.

5. Japanese monetary easing: Under the leadership of Japanese Prime Minister Shinzo Abe, Japan has engaged in a broad scale reflation program. “Abenomics” has had tremendous effects on the country’s currency and equity markets, which should continue going forward. Managers have profited from this shift in Japanese monetary policy through momentum and relative value trades. Directional positions have included short Yen, short Japanese Government Bonds (JGB) across various maturities, or long equities in Japanese exporters, real estate and construction companies and financial institutions. Relative value positions include short Yen versus long JBG, as the latter is backstopped by Japan’s bond purchasing program. While many of these markets have already had substantial moves, managers continue to focus on Japan and are monitoring the next stage of the program (i.e., structural reforms such as domestic wage increases), which could revive momentum.

6. Global reflation: Term structure trades, also known as flatteners or steepeners, are a common relative value tactic employed by global macro managers. Over the past several years, developed nations’ long-term interest rates have been at their lowest levels in a very long time. As the Federal Reserve embarks on tapering its quantitative easing program and developed economies continue to improve, long-term interest rates are expected to rise. As such, interest rate term structures will steepen, but the process is unlikely to be in a straight line. This could create both tactical and long-term trading opportunities for macro managers specializing in the fixed income space. In addition, many managers also feel that European interest rates will follow a path similar to that of the U.S., but with a lag. This should broaden the universe of investable markets for macro managers who understand the factors that affect the relative value of fixed income securities across different maturities and denominations to capitalize on.

Conclusion
In this article we outlined why we favor discretionary global macro strategy and underweight CTA/managed futures. While we feel most strongly about these strategies, we also continue to find other, more niche macro-focused investment opportunities (e.g., co-investment opportunities with commodity-focused managers, fixed income relative value-oriented hedge funds that at times appear macro-oriented, and systematic global macro hedge funds that trade on longer-term signals) appealing.

As we previously noted, macro-focused investing can come in many forms. Selecting the appropriate manager and investment strategy requires a strong understanding of the investment approach and instruments used. One can benefit from monitoring and evaluating a large number of funds across all sleeves of the macro-focused investment space. Ongoing discussions with the investment team managing the fund, thorough analysis of its portfolio, including reviewing the specifics of individual trades and evaluations of the investment team’s risk management process and systems can help build conviction in specific managers.

In general, we continue to believe that the macro-focused investing space will present attractive opportunities for investors, but as always, will require careful evaluation and selection at both the sub-strategy and individual manager levels.

1 “How investors lose 89% of gains from Futures Fund” Bloomberg Market Magazine, October 7, 2013.