Recent US economic data has clouded the outlook for US monetary policy. The US ISM Services purchasing managers index fell to 50.3 in May, below consensus and indicative of flat service sector growth. US labor data was mixed. While US nonfarm payrolls outshone expectations for the fourteenth consecutive month in May, a monthly fall in the household survey and uptick in the unemployment rate to 3.7% offered a hint of slackening in a tight US jobs market.
We believe that persistent risks may mean macroeconomic uncertainty will stay high. Gauges of US equity market volatility arguably do not reflect these risks—the VIX Index stands below 15 and at post-pandemic lows. And with the potential for higher volatility in less liquid markets over the coming “holiday” months, investors concerned about swings in their portfolio’s value should consider diversifying with alternative investments like hedge funds.
For investors underallocated to hedge funds and looking to build long-term positions, discretionary macro hedge funds may be an interesting “first port of call” ahead of potentially stormier seas:
They typically benefit from high uncertainty and volatility. Macro hedge funds aim to take advantage of shifting macroeconomic trends and market dislocations during transition periods. Discretionary macro managers can also be very tactical in nature while swiftly reducing their positions when trades don’t pay off. They generally avoid less liquid credit and other non- liquid investments and tend to have low “participation risk” in crowded trades. These types of strategies have the greatest trading flexibility of all hedge funds, taking positions across regions, sectors, and asset classes.
These strategies tend to outperform diversified hedge fund benchmarks (HFRI Fund Weighted) during periods of higher interest rate volatility, based on Bloomberg and BarclayHedge data back to 1998. While rates volatility gauges like the MOVE Index remain below their March 2023 highs, ambiguous US growth and inflation data may lead to more pronounced swings in US yields, supporting macro hedge fund performance.
They may stabilize portfolios in slowdown or recessionary phases. In our base case, we expect most world economies to slow in the second half of 2023, before potential rate cuts spur a more sustained growth acceleration next year.
While history is no guarantee of future performance, macro hedge funds have generally helped to reduce portfolio swings, especially during times of economic slowdown or recession. Between 1997 and 2022, macro hedge funds generally outperformed other hedge fund strategies (HFRI Fund Weighted Index) by 1 percentage point (1997 to June 2022) during manufacturing slowdowns and by 12 percentage points (over the same period) during manufacturing recessions (all based on BarclayHedge and HFR data, using global industrial production as a business cycle indicator).
They can help to limit losses during market declines. We prefer bonds to equities in our global strategy. Our base case is for developed market stock markets to fall 1–9% by year-end, with potential for up to 20% losses in a so-called “hard landing” scenario.
Historically, macro hedge funds have shown shallower peak-to-trough losses during market selloffs. Discretionary macro recorded a maximum drawdown of 8.1% over the 1997–2022 data period previously cited, compared to a 50.9% max drawdown for US equities (S&P 500 Total Return Index). And while discretionary macro funds exhibited modest positive return correlations to global bonds (0.28) and global equities (0.54), we would note that macro hedge funds have delivered negative return correlations to equities during periods of acute market stress. This suggests discretionary macro funds may even be able to post gains during times when equity markets post particularly steep losses.
So, for investors concerned about economic uncertainty, market gyrations, and the potential for stormier seas ahead, discretionary macro hedge funds may be a good place to begin hedge fund investing, as part of a well diversified portfolio.
We continue to believe in the long-term role of hedge funds as a means of diversifying returns and managing risks. We also see return potential in multi-strategy funds, equity long/short funds with low net exposure, and credit long/short funds.
Investors should be mindful of the potential general risks of investing in hedge funds. These include the potential illiquidity of the fund; the lack of transparency of some managers, which could be used to mask fraud; and operational risks, such as improper risk management or leverage. Investors seeking to mitigate these risks should carry out due diligence and observe strict investment and monitoring processes.
Main contributors – Solita Marcelli, Mark Haefele, Tony Petrov, Matthew Carter, Christopher Swann, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Macro hedge funds – a steady ship in stormier seas, 06 June 2023.