Ending the cult of loss aversion in global macro

With macro markets finally starting to percolate nicely, the following is a guest post by friend-of-the-blog Neil Azous of Rareview Macro.  Neil's piece reflects many of the conversations that Macro Man has had with friends the industry, and was originally published here.

The 2008 financial crisis exposed institutional money managers to a range of risks for which they were not prepared. Some of these were market risks, in which the value of their investments declined more than they had previously imagined possible. Some of these were liquidity risks, in which still-viable strategies gated their funds, thereby preventing investors from getting their money out. Finally, some of these were operational risks, in which the demise of Lehman Brothers and the Madoff scandal highlighted the importance of factors such as accounting, compliance, and infrastructure, as well as just performance when it came to choosing a fund.

In the wake of a traumatic loss, whether it is financial or personal, it is just human nature to overcompensate to make sure the experience is not repeated. But while that is understandable, it is rarely the best response. And so it has proved for many hedge fund investors over the past few years. While one could argue that each of the investor responses highlighted above has damaged investment performance, this article will focus on one specific issue:  the cult of loss aversion in global macro investing.

Although some global macro funds performed strongly during the financial crisis, others were caught up in the maelstrom.  As a result, while the strategy attracted strong inflows in 2009-2010, enthusiasm was tempered to a degree by the realization that an idiosyncratic macro investment would not automatically guarantee a hedge against generalized market stress. At the same time, the recipients of these inflows were keen to maintain their larger asset bases and the fees associated with them. This has become a particularly important factor over the last several years as conventional strategies have performed strongly, and with investors demanding positive returns in macro regardless of the underlying market and policy dynamics.

The result has been a concentration of assets under management (AUM) amongst a few very large funds, many of which fetishize loss avoidance over all other factors in trade selection and risk management. Of course, risk management is an important part of any robust investment process.  However, in modern macro investing the cult of loss aversion is becoming counterproductive given the fundamental and market outlook.

These days, most macro managers can be more accurately described as ‘hedged’ than ‘absolutely discretionary return’ investors. When legendary traders such as George Soros or Stanley Druckenmiller were making a name for themselves in the British Pound or Equities (yes, he was long a lot of them) they did not have a “hedge” against those positions because they truly believed in them. Sadly, very few macro managers have this level of conviction these days. They are too worried about taking a loss rather than a making huge profit.

In a world of many independent opportunities and a widely-dispersed asset base, it is completely rational for firms to use tight trade- and portfolio-level stop losses, because with rare exceptions (such as during times of acute market volatility) each stop loss decision has little bearing on the behavior of the market as a whole. Unfortunately, this does not describe the current state of the market.

Thanks to the static monetary policies operating in many major economies, there are relatively few independent investment opportunities with sufficient market liquidity to absorb a thematic allocation from a large global macro fund. As a result, the few such trades that do exist very quickly become over-crowded, particularly by the few large funds that dominate the AUM base of the strategy. Unfortunately, this leads to paranoia and a fear of loss rather than a healthy balance between risk taking and risk management.

When the markets do move, portfolio managers are incentivized to take profits or reduce risk very quickly. Why? Because macro investing has become a game of musical chairs, where investors need to make sure they are not the one caught out when the music stops. Those on the right side of the market, aware that most of the past five years have been characterized by range trading in foreign exchange and fixed income, move to ensure that they do not drawdown their investment gains. Those with losing positions, on the other hand, do not feel able to view markets through a value prism, and instead worry about the possibility of hitting their modest loss thresholds, and thus closing out positions at disadvantageous levels. Consequently, the de facto “macro” time horizon has been compressed into a few hours to a few weeks, leaving relatively few able to capitalize on the thematic gains that have traditionally characterized the strategy.

Although generating a 10%-12% gross return should not be a particularly hard target in an environment where risk parity funds have produced 20%+ annualized gains over the last few years, the current focus on loss avoidance above all else has condemned the macro strategy to a performance that is mediocre at best.  If a portfolio manager is unable to weather a 5% drawdown without having his risk allocation cut or eliminated, how is he to participate in the type of trades that generate double digit returns? The answer is he cannot. Unfortunately, what is individually rational (i.e. cutting risk quickly to avoid hitting drawdown limits) has proven to be collectively irrational as the industry careens from stop-loss to stop-loss.

This negative feedback loop has provided even more incentive for investors to allocate elsewhere, and very often to managers dedicated solely to one asset class, including funds that are far less focused on loss aversion or a metric like a Sharpe Ratio. Remember, investors can market returns. They cannot market a Sharpe Ratio.

It is ironic that the macro strategy has lost its way considering the opportunity for out-performance from some of the big themes of the last four years – long Equities (yes that is a macro investment), long Interest Rates, long Credit, and short Volatility – was very large. These were strategies that in previous cycles made big profits for the macro managers who got them right.

They can do so again. That is why the call right now should be to re-think how investors look at risk. What investors should demand from their managers is a return to old-school macro investing, where themes are given time to play out, portfolio turnover is significantly reduced, and more focus is placed on absolute returns at the expense of fetishizing drawdown limitation.

At the very least, investors should take a look at the macro managers that have evolved post the Global Financial Crisis. A new breed of portfolio managers are emerging who  are “risk conscious” and use their expertise in derivative products to add both edge and control to concentrated investing. True, their absolute AUM pales in comparison, and certain strategies may have liquidity constraints in terms of scale, but it is becoming easy to identify this group of “risk conscious" managers from those simply focused on loss aversion.

Additionally, the sector needs another George Soros, who generated 25%+ returns year after year, with a Sharpe Ratio lower than a diversified US 60/40 benchmark. How was that done? By believing in his themes and betting big. Otherwise, it is just a matter of time before investors realize their collective actions have squeezed the risk appetite out of managers and left the global macro landscape without an edge.

Should such a change occur, there are plenty of thoughtful managers who will again reap significant benefits for investors.  Recall that the so-called golden age of macro investing featured concentrated positions, higher volatility, and a somewhat lower Sharpe ratio.  However, it also offered excellent diversification against a portfolio of risky assets and generated large absolute returns.

Until then, we can only hope that current circumstances are not merely incentivizing those with the best marketing pitch  and the quickest trigger finger, but instead rewarding the truly talented while weaning out the less skilled….the way Darwin meant it.
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Anonymous
admin
September 9, 2014 at 2:30 PM ×

Much as I agree with the sentiment here, the multi PM fire at -4% model is stupid and needs to go - its just too hard to make fees work this way, i think something important thats missing here is that rates were way higher - 100-300% long bonds used to pay a heck of a lot, plus the interest on cash.

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VandalsStoleMyHandle
admin
September 9, 2014 at 2:32 PM ×

I agree with a lot of the sentiments about the general malaise afflicting the industry, but I think there's a degree of selection bias when looking at the glories of the past. After all, for every Soros, how many have-a-go heroes have blown up and been forgotten in the fullness of time. Or perhaps it's even worse: I fear that the Soros's and Druckenmillers of this world have provided cover for a lot of have-a-go heroes, who've gone on to sully the macro brand.

Another issue is: are we sure there's a problem that needs solving. Global macro has become institutionalised and accordingly neutered, but maybe Alan Howard et al are happy enough earning their management fees on vastly greater piles of assets. They've handed in their 'Live free or die' t-shirts, and are now working for The Man, thank you very much.

OK, granted, it's no fun for us macro minions, but we're the tail, not the dog.

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Anonymous
admin
September 9, 2014 at 3:04 PM ×

the piece forgets one thing: who is the investor pulling the trigger.

These days the selector is a professional i.e. a guy paid by somebody else that needs to throw the dart on the board.

This guy wants to protect his culo. he is not going to select the most volatile because hish swings could upset his boss/investor.

he goes for the fund that tells him he is going to sleep at night.

Robust risk management architecture/tail risk analysis of idiot-syncratic risks/PCA/Copula/non-parametric are his sleeping pills.

And on the back of that, fund managers end up having a 3:1 ratio which - statistically is bollox.

Then, investors always buy what has performed best last year. I always say...

God gives you an information ratio of 1.0. Under the normal distrib assumptions, 1 year out of 6 you lose money.

if it happens on the 6th, you may go away with it... but if it materialises on the first one are you going to have a second?

ciao f

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Anonymous
admin
September 9, 2014 at 4:00 PM ×

i think the comment on 'is it it problem and institutionalised nature' is also right - hnwi's were fine with the big swing, japanese pension funds are not, they will invest orders of magnitude more than hnwis and want 7% over 10y jgb. good example is winton halving the funds vol target.

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Leftback
admin
September 9, 2014 at 6:03 PM ×

Macro funds are just another class of victims of what is rapidly becoming global financial repression, along with savers and "value" investors. Historical comparisons are somewhat inane in this case, as e.g. Soros made his name and money in a vastly different regime - higher rate, high FX vol environment. That was long before we stepped through the looking glass into ZIRP.

Quick quiz: name a massively successful Japanese macro HF over the last twenty years... (crickets chirping) OK, now since, that was the laboratory for the present global situation, why expect the recent US and EU based macro HF results to be any different?

Changing the topic, do punters here have a view on why USDJPY is decoupling from everything this week? Is it merely b/c it was the MM readership poll's favored EoY Hail Mary performance chaser?

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Anonymous
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September 9, 2014 at 6:07 PM ×

C Says
LB,
Yenny is down to me ! Best thing I have had running for quite awhile.

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amplitudeinthehouse
admin
September 10, 2014 at 1:28 PM ×

Never short a quite market they say, well , how about never short a bank looking to erase volatility from its books.
With the referendum in the pipeline I'd be curious to know which Scottish Banks have done thee above since 2008.
With help from London subsidiary's (thank you) one can say the desk is all focused again like a Thoroughbred running down the straight for the first time in blinkers.
Thanks mate.

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Yeno
admin
September 10, 2014 at 1:51 PM ×

@LB - BOJ are actively selling Yen in the market.

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Anonymous
admin
September 10, 2014 at 2:04 PM ×

What's so good about a low Sharpe Ratio?

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River
admin
September 10, 2014 at 2:55 PM ×

A good read,imo:

"He expects the dollar to strengthen substantially against the Japanese yen, which is likely to continue being devalued. Eventually, he sees the dollar USDJPY rising to ¥200 (it was at ¥106.40 on Tuesday)".

http://blogs.marketwatch.com/thetell/2014/09/09/jeffrey-gundlach-gives-market-calls-and-outlook/

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Leftback
admin
September 10, 2014 at 3:20 PM ×

US30y flirting with the 50 day average today, as the long bond auction comes into view tomorrow. Time for some fixed income bargain hunting. A 2.55% 10y and a 3.25% 30y beat their peripheral European counterparts and a share of AMZN quite handily here. Jeff Gundlach was being fairly conservative with his public call of 2.2-2.8% US10y, probably he doesn't really believe US yields can drift that high now that even core Europe is heading for deflation.

DX looking up at 85 here, USDJPY at 107 with no sign of stopping any time soon on the way to 110. It will probably take another really piss weak employment number in the US to stop this runaway train. That's likely to happen soon, as we have seen DX 85 before and it usually stops US export growth and domestic inflation abruptly.

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Anonymous
admin
September 10, 2014 at 3:48 PM ×

Does this ever end?

Big Banks Manipulated $21 Trillion Dollar Market for Credit Default Swaps (and Every Other Market)

http://www.washingtonsblog.com/2014/09/big-banks-manipulated-21-trillion-dollar-market-credit-default-swaps-every-market-well.html

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September 10, 2014 at 4:25 PM ×

I think we are seeing macro live in "crypto macro": multistrat and equity managers which for some reason or other get a pass on volatility and use that to show the staying power that the Brevan's Millennium's etc of this world don't have. Old school macro is alive, but its buried in "tail" and "macro" allocations within multistrats where at 10-15% of AUM it can move the need in a big year but is outside the purview of FoF weenies.

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Leftback
admin
September 10, 2014 at 8:22 PM ×

+1 for "FoF weenies". Tautologous, but Quality.

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Mr. T
admin
September 10, 2014 at 8:34 PM ×

For me risk aversion and the 'cult of taking small profits' is a result of constantly having to put on positions you do not believe in, because you know the market is being pushed in those directions.

My post-2008 trade idea generation pretty much always starts with something like "what does [some-central-bank] want out of this market?"

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Anonymous
admin
September 11, 2014 at 6:20 AM ×

C says
Mr T,
Ditto, couldn't agree more on all points made.

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Anonymous
admin
September 11, 2014 at 7:28 AM ×

Anon @ 3:48.

This ain't exactly breaking news. The biggest dealers in the market sit together and decide what constitutes a credit event for example. It is all official and called ISDA standard. When pooh hits the fan, for example whem Thomson had a credit event back in 2009, things become interestig. Everyone would have said that this was a default, plain and simple, but it ended up as a restructuring... with different implications for the protection buyers. There is no way to win when the bank decides the odds once the dice have been cast.

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macrottt
admin
September 12, 2014 at 9:12 AM ×

Interesting article.
But there are two major causes not discussed here which are contextual I think.

1/ Soros investors were wealthy guys who wanted to make 50% yearly, now most macro HF investors are institutionals - pension funds etc, very happy with a 8% yearly as long as the sharp is good. The good news (not that sure?) is that apparently pension funds are reducing their exposure to the HF sector.

2/ It is QE times that has messed things up. Look what happened to the "big" ones in Q3 2009, or on Fed taper in Q2 2013. They got completely killed with the wrong strategies. QE has completely distorted our investment tactics. It is liquidity that has been driving price trends rather than data, that's why every macro investor had to shorten their duration. Moreover, everything was so correlated, that you couldn't bet on any one differentiated theme. That's why risk management has become so important. At Soros times you could buy some 2Y notes and keep them for 3 years, in a super mega trend. Macro trends had nothing to do with the current context. The good news again is that with the Fed exit, we now have policy divergence. It is getting trendy, data and policy driven...

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