Macro hedge funds have been among the most volatile hedge fund strategies, even as they diversify when investors need that the most.
AQR argued in research published this week that macro can be done more smoothly.
Managers of global macro hedge funds have generated high returns through big market bets, such as shorting mortgage markets before the global financial crisis. But they’ve also suffered losses when concentrated bets like those on the direction of monetary policy or international trade haven’t panned out.
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“A combined systematic/opportunistic approach can provide investors with smoother returns and fewer fluctuations in portfolio volatility, across macroeconomic environments,” according to the paper’s authors, AQR’s Paras Bucrania, Chris Doheny, Jonathan Fader, and Caroline Heinrichs.
“Our research has identified profitable approaches to macro investing that may be more repeatable in the long run,” the authors continued.
AQR’s paper, called “Fundamental Trends and Dislocated Markets: An Integrated Approach to Global Macro Investing,” hinges on two ideas. First, markets often underreact to news about macroeconomic events and slowly move to incorporate actual changes. Secondly, security prices are sometimes completely out of whack with real value. These phenomena may be driven by anchoring, herding, or other common behavioral mistakes. For example, if investors are anchoring their assessment of fair value to current prices, they may be slow to update their views.
“However, when clear and sustained trends in fundamentals and prices do emerge, investors may, in fact, overreact to these trends, taking for granted that fundamentals will continue to move in the same direction,” wrote the authors. “Overextrapolation may lead to herding behavior and an overshoot in prices.”
AQR explained that a systematic macro strategy looks to quickly identify fundamental shifts, so funds can benefit when prices eventually move to reflect the changes. Using the approach, managers would position a portfolio within equity indexes, government bonds, shorter term interest rates, and currencies. Conversely, an opportunistic approach could identify when prices are misaligned with fundamentals. Opportunities are identified systematically, but analyzed individually for misleading signals. Then capital could be deployed to take advantage accordingly.
AQR’s backtests suggested that a macro strategy marrying systematic with opportunistic could deliver consistent returns across economic environments and still diversify.
The hypothetical investment delivered an average annual excess-of-cash return of 12 percent for the backtest period of 1993 through December 2018. The annualized standard deviation was 10.5 percent and the Sharpe ratio was 1.2.
“It should not surprise us, therefore, that these strategies generate highly diversifying returns despite trading an overlapping universe of macro assets,” according to AQR.
“By integrating these highly complementary approaches, investors may gain access to a source of alpha that is diversifying to both traditional and alternative investment,” the authors argued.