Should macro funds trade like Bill Ackman?

And so the big day arrives yet again, the penultimate payroll before the "will they/won't they" FOMC meeting next month.   Most asset prices were suitably subdued yesterday, as bitter experience has demonstrated that making bets on the outcome of a payroll figure is more akin to gambling than trading or investing.  For what its worth, Macro Man's model suggests a payroll print of 201k...above the published consensus but bang on the whisper number as generated by the fun Bloomberg WHIS function.

One thing that did move yesterday, of course, was sterling and UK fixed income, thanks to another dovish masterstroke by the generously compensated Mr. Carney.  As they say where Macro Man grew up, "the boy sure can talk", though in watching Carney's press conference your author couldn't help but observe that the more Carney talked, the less he said.  No doubt by the end of the year, Carney will have changed his clown suit stripes yet again.

Macro Man doesn't really trade many single securities and usually refrains from commenting on them, because he doesn't generally have enough knowledge to render a sufficiently informed opinion.   However like many others, he suspects, he has really enjoyed observing the whole Valeant kerfuffle from afar.  Regardless of whether they have committed fraud (and from afar this whole Philidor business certainly appears dodgy), their morally reprehensible business model (acquire the rights to medication that someone else has developed and then jack up the price) makes them an easy target to root against.

The whole Bill Ackman thing, however, has got Macro Man thinking.   While Mr. Ackman is undoubtedly a talented portfolio manager who puts in a lot of work, he is far from infallible.   The one trade or position of his that Macro Man feels competent to pass judgement on, his long HKD reval bet of a few years ago, was a stinker that was obviously ill-judged at the time.  Just because low-delta HKD option vol was low did not mean it was cheap, a fact demonstrated when Mr. Ackman paid silly prices for stupid options.   Moreover, the underlying view both misjudged the Hong Kong economy and the political will to maintain the peg.  (Although Macro Man was not authoring this blog at the time, he did discuss the trade in real time with a few market counterparts and expressed the view above.)

So Mr. Ackman is clearly not infallible.   When he went on CNBC the day that the Citron thing broke and bragged that he bought another 2 million shares of Valeant, it certainly looked like the decision was made with his trouser region rather than his brain.  While the extra $60 million that he pissed away on the trade by playing Billy Big Boots may be a drop in the bucket for Pershing Square investors, it's not like he has P/L to spare this year.  Moreover, given the dearth of public disclosure that Valeant had made about Philidor, it seems unlikely that the decision was made on the basis of adequate information; and if it was, how did Ackman come by it?

This is not meant to be a go at Mr. Ackman (though it generally is nice to see hubris vanquished by nemesis.)  Rather, what struck Macro Man about the whole episode is the leeway granted to equity managers to lose money, add to those losing positions, and brag about it on TV.  This is just not something you see in macro- at least not any more.  Obviously Stan Druckenmiller made some headlines recently, but those were more general thoughts than specific trades (other than the short euro.)  You certainly didn't see the guys at Fortress or anyone else who got killed by the SNB appearing on CNBC in January saying "those guys are numb-nuts and the Swissie's overshot.  We're buying more!"  Instead, by incurring losses comparable to Ackman's over the last few months, they went out of business.

Macro Man has written previously about the restrictions placed on most macro punters these days in terms of volatility and drawdowns.  Simply put, there's not much appetite for the former and zero for the latter.  Part of this pressure comes from the asset allocation model of "get 50 guys in  a room and sack anyone who loses money", but on a bigger picture basis investors just aren't willing to incur any losses or give their managers leeway to take proper strategic bets.

Yet this is the very leeway accorded to Mr. Ackman; while one could argue that this leeway is a function of his skill, one could also question how much of his skill is a function of the leeway?  In other words, how would Ackman operate in the "no drawdown" model of modern macro....and how would macro operate in the "no worries" model of Pershing Square and other equity funds?

It's interesting, of course, that things used to be like that "back in the good old days" of the 1990's.  If we look at the weighting of the CS Broad hedge Fund Index, which starts at the beginning of 1994, we see that for a time macro was the dominant asset class back when Quantum et al. were in their pomp.   The mantle was taken over by the long/short equity guys during the Internet bubble, and macro's been an afterthought ever since.

                                                          Source:  www.hedgeindex.com

(It's interesting to note, however, that despite the publicity given to the Ackmans of the world, long/short equity was supplanted a long time ago by event-driven strategies.)  For fun, Macro Man decided to play with the Credit Suisse HF sector indices and generate an optimized basket of the indices, and compare the optimal weightings with neutral weightings.

He used the 10 sectors listed in the chart above:

* Convertible bond arbitrage
* Short bias
* EM
* Equity market neutral
* Event-driven
* FI arbitrage
* Global Macro
* Long/short equity
* Managed futures
* Multi-strategy

The basic methodology was to give each index a coefficient of 1 (non vol-weighted) and simply take the average return of the 10 sectors to create a 'neutral weighting basket.'  Obviously this approach disregards things like capacity, liquidity, etc.

He then ran an optimization to adjust the coefficients to maximize the risk-adjusted return of the sector basket, but with the proviso that each sector's minimum weight was 20% of its neutral weighting.  By comparing the optimized weights with the neutral weights, we can therefore see which sectors the numbers suggest should be taking more risk...and which should be taking less.   Rest assured that Macro Man had no idea what the numbers would look like when he embarked on this little project, and only adjusted the methodology once (implementing the minimum 20% weight when his first optimization left 8 sectors with zero weight.)

Here's what the results look like since the beginning of 2006, which ironically was more or less the last time the Fed was hiking rates:

Well what do you know?   Despite having the lowest actual vol since 2006, macro gets the second-highest optimized vol, with the optimizer recommending a vol weighting more than double its original level.  OK fine, you say, but that's a legacy of the crisis, when some macro funds did OK while the rest of the industry got crushed.   What happens when we strip that out, because nothing like that will ever happen again, right?  Right?  Let's take a look at the numbers since the start of 2011- let's call it the "forward guidance era."

Yet again, macro has one of the lowest actual volatilities over the last 5 years....and once again the optimizer wants to more than double the risk taken in macro, this time to the highest weighting of any of the 10 sectors.   Again, Macro Man promises you that this is a first run analysis with no priors embedded or fiddling done afterwards.  But what have you done for me lately, you ask.  Once more unto the breach, this time running the same analysis over the last 24 months:

More recently, macro vol has been middle-of-the-road (though that says more about other sectors than it does about macro)...and the optimizer yet again jacks it up to the second highest weighting.  Curiously, the highest weighting is given to short bias, despite negative overall returns...such is the power of diversification!

Macro Man has a few observations about the exercise as a whole:

* The optimizations clearly liked the diversification benefits of macro relative to the other sectors; managed futures also confers those benefits, but with a generally inferior risk-adjusted return profile.

* The volatility of the individual sectors and the neutral and optimized baskets has steadily trended lower.  This is not only a function of 2008 falling out of the equation, but also of the pressure post-Madoff to be on top of any losses whatsoever.

* The irony is that as the risk-adjusted return went higher as Macro Man shortened the analysis window, the nominal returns trended lower.   Although there are plenty of facile criticisms of the hedge fund industry in terms of failure to match the returns of the SPX or a simple asset allocation basket, one has to consider what investors are asking for.  If they are asking for funds to maximize return: risk ratios rather than nominal returns, then that's what they are (or could be) getting.   Certainly Macro Man's personal experience and that of macro at large is that there is little appetite for Ackman-style strategic bets come hell or high water.

* It is interesting to see, therefore, that the math suggests that given returns and correlations, macro should still be allowed to take twice as much risk as they have been as part of an ideal portfolio construction.

* On each of the time frames analyzed, in fact, macro was given a higher weight than long/short equity.   Take that, Ackman!

* One possibly legitimate criticism of this approach is that the returns of the CS indices are not representative of the hedge fund industry as a whole and macro in particular.  Hedge fund indices have well-known biases that distort the returns higher, and the returns for macro are not consistent with those observed by, for example, the HFR macro hedge fund index, which has generally declined since the crisis.  One benefit of the CS indices, however, is that one can actually see the funds that comprise the index, whereas Macro Man hasn't got a scooby who's in the HFR index.   (FWIW, both Pershing Square and Macro Man's former fund are both currently in the index.)

So there you go.  A chap calling himself Macro Man performs an analysis that suggests that global macro funds should be allowed to take more risk (and perhaps, cough, hire more punters.)  As shocks go, that's right up there with Carney flip-flopping again and making another pisspoor prediction that will go wrong within a matter of weeks....