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.