Hedge fund investors seek protection in macro uncertainty

Macro factors are driving hedge fund investors to reassess their positioning as central bankers signal an end to ultra-stimulative monetary policy in developed markets.

Hedge fund investors are positioning for a summer of macro uncertainties as central bankers signal an end to ultra-stimulative monetary policy in developed markets.

News of the US Federal Reserve’s intention to end its second round of quantitative easing (QE2) on schedule in June, confirmed by chairman Ben Bernanke, sparked a major sell-off in stocks, commodities and other risk assets.

Renewed concerns over sovereign debt problems in the European Union’s eurozone members, weaker than expected economic data and rising inflation in China also contributed to a spike in volatility and reinforced the bearish sentiment among market participants.

The sudden reversal appears to have caught many hedge fund managers by surprise.

Commodity trading advisers (CTAs) and discretionary macro managers were long energy and precious metals and bore the brunt of the reversal in commodity prices.

The HFRX Macro Index was down 3.14% through May 24. Equity hedge strategies fared even worse, losing 4.08% over the same time frame, according to Hedge Fund Research.

The HFRX Global Hedge Fund Index declined 2.13% in the three weeks to May 24, its worst performance since May 2010.

The losses have prompted hedge fund managers and investors to adopt a more defensive stance.

“Fund managers have reduced risk levels across the board,” says Jack Flaherty, a portfolio manager in the fixed income group at GAM. He expects most funds to remain conservatively positioned through June and into July while the macro picture comes into sharper focus.

The correction in May has a sense of déjà vu about it. This time last year the S&P 500 fell almost 20% and commodity prices declined sharply after the Fed ended its first quantitative easing programme (QE1) and concerns over Greece’s public finances bubbled to the surface.

With markets in freefall, the EU agreed a €110 billion ($154.3 billion) bailout package for Greece and the Fed was effectively forced to announce QE2 in late August 2010 to counter the threat of a double-dip recession.

The S&P 500 has rallied more than 25% since then and commodities have done even better.

Investors believe the end of QE2 will have a less dramatic impact on the markets. “We’re not expecting to see the same outcomes as we did when QE1 was taken off the table,” says Scott Gibb, managing director in the fund of hedge funds (FoHF) group at Cube Capital.

The renewed concerns over Europe’s sovereign debt problems and the slowdown in US economic data are reminiscent of last year, but existing fiscal stimulus measures and the Fed’s decision to reinvest the proceeds of maturing securities are likely to provide temporary support, says Gibb.

However, he thinks fundamentals are stretched and expects to see an increase in volatility and “a soft patch” for traditional risk assets over the summer months.

Cube expects event driven and distressed strategies and sector-focused long/short equity managers that maintain low exposure to the markets to outperform in this environment. It also has exposure to a number of defensive strategies including discretionary macro and managed futures which Gibb believes will protect the portfolio in the event of a major slowdown in global growth.

Flaherty believes commodities, “which have been driven up to pretty crazy levels since last August”, will bear the brunt of the QE2 correction.

Crude oil tumbled almost 15% in May but is still up around 40% from a year ago. Gold is down only around 1% after recovering from steep losses earlier in the month while silver fell around 25% after more than doubling over the past year.

By contrast the S&P 500 has been relatively resilient, giving up only around 3% for the month through May 23.

Flaherty believes lower energy costs, healthy corporate balance sheets and rising profits will help support stock prices and sustain the US economic recovery once QE2 is withdrawn.

“We think private capital is ready to take the baton from the Fed,” says Flaherty. “There is a huge amount of cash on corporate balance sheets and boards are feeling more confident. We see this reflected in the increasing levels of corporate activity, particularly mergers and acquisitions and share buybacks.”

The credit markets have also shaken off the worries over QE2. High-yield bond spreads have continued to tighten. Yields have fallen to an all-time low of just under 7%, although the spread over Treasuries is still above pre-crisis levels.

“In the high-yield market it is as ‘risk on’ as it has ever been. Prices have been bid up but the risk premium is still compelling given the low default rate,” says Flaherty.

GAM’s fixed income team continues to see value in high-yield bonds and has exposure to the equity story though convertible bond positions in its absolute return portfolio. Other groups at GAM have large allocations to equities, says Flaherty.

Michael Beattie, chief investment officer at fund of hedge funds (FoHF) Tradex Global, is more bearish than many of his peers. He slashed Tradex’s exposure to long-biased credit and equity managers and commodities in April in expectation of an ugly end to QE2.

“I don’t think the private sector is ready to take the reins from the Fed,” says Beattie.

He expects a slowdown in gross domestic product (GDP) growth in the US and for unemployment to hover around 9% through the summer. This could force the Fed to implement a further round of stimulus “in the form of QE3 or QE2.5” before the end of the year, he says.

The Fed has said it plans to continue re­investing the proceeds of maturing securities in its portfolio after QE2 officially ends in June. However, Beattie believes that may not be enough.

“The Fed has a dual mandate to promote maximum employment and stable prices. If we have unemployment above 7%, below-target inflation and muted growth, that calls for another round of quantitative easing. Bernanke has plenty of room in his inflation and employment numbers to be aggressive,” says Beattie.

Tradex has implemented an overlay to protect its portfolio against heightened volatility while QE2 unravels. The overlay consists of short equity and long volatility positions, an allocation to gold and a long bet on the US dollar expressed through deep out of the money call options.

Tradex’s flagship FoHF portfolio has exposure to market neutral and event driven equity strategies, including merger arbitrage, emerging market funds and CTAs, which Beattie believes are attractive due to their long volatility bias.

GAM’s Flaherty sees the debt crisis in Europe as a bigger tail risk than the end of QE2. “If things take a turn for the worse in Greece, Portugal and Spain, that could expose the European banking system to further losses and undermine the global economic recovery,” he says.

He believes the market may be under-pricing the risk of a default or forced restructuring in Greece. GAM has taken advantage of tighter credit default swap (CDS) spreads to purchase protection on European banks. “The price of insurance has fallen considerably but the European banks are not out of the woods yet,” says Flaherty.

Europe’s debt problems could derail the slow-grinding global recovery, says Gibb. “Greece and Portugal are insolvent and will need debt restructuring,” he argues.

European Union leaders appear hesitant to deal with the issue and are struggling to garner the political support to do what is necessary. However, there is a realisation that a failure to resolve the debt problems in Greece, Portugal and Spain could result in a crisis on the scale of the Lehman bankruptcy.

Gibb says EU leaders will likely “do everything but the right thing until they have exhausted every other option. The longer they dither and kick the can down the road the more expensive the European crisis will be for all.”

The clock is already ticking. Greece and Portugal have slipped back into recession and the outlook is for slow growth in the region for a significant period of time.

Cube is just as concerned about the outcomes of China’s battle against inflation. The People’s Bank of China raised interest rates in April for the fourth time since last October but the hikes have done little to dampen inflation which continues to run at around 5%, above the government’s 4% target.

Gibb believes the Chinese authorities will continue to raise rates and reduce capital investments in a bid to snuff out inflation. “The Chinese authorities have warned business leaders to brace for hardship over the coming months as they tighten,” he notes.

“The situation will have to be managed carefully. A hard landing in China could put the global economic recovery in peril,” Gibb adds.

Cube is underweight in the Brics (Brazil, Russia, India and China) which are “crowded and expensive,” according to Gibb, and is defensive on commodities in expectation of slowing demand from China.

Gibb believes “emerging market laggards” like Vietnam could outperform the Bric countries if the global recovery grinds on. “We see opportunities in emerging markets with a turnaround story where there has been very little capital flow and where valuations are compelling. If the recovery persists we believe capital will flow to markets where valuation and growth are more compelling rather than to the crowded Brics.”

The end of QE2 and more pronounced imbalances between the world’s major economic blocs should create a more attractive environment for discretionary global macro managers, says Javier Uribarren, investment director responsible for macro strategies at Stenham Asset Management in London.

The risk on/risk off dynamic that has characterised markets in the past year has shortened trade horizons and exposed macro funds to frequent price reversals. Global macro funds returned around 8% on average in 2010 and are broadly flat for the first six months of this year. But Uribarren believes the strategy will benefit from clearer, more pronounced trends in the second half of 2011.

“The significant government influence in markets has made it difficult for macro funds to generate consistent returns over the past 18 months,” he says. “The Fed’s reduced role in the markets is a clear positive for macro funds. They perform better when markets are driven by economic fundamentals rather than ­government policy.”

Some of the macro managers in Stenham’s portfolio are short the US dollar and Treasuries in durations the Fed was previously purchasing for its QE2 programme. They are also positioned for higher long-term interest rates, says Uribarren.

He says Stenham is allocating mainly to discretionary macro managers that take an opportunistic  approach rather than long-term trend-following CTAs “which are curently positive correlation to risk asset direction”.

The long-term outlook is for higher inflation and interest rates in developed markets. The European Central Bank (ECB) raised rates in April for the first time since 2008 and markets are pricing in another hike in July despite the debt problems of peripheral eurozone countries.

The Fed is in no rush to tighten “but ultimately we’re heading for an environment of higher rates than we have seen in the past 20 years,” says Flaherty.

Tradex’s Beattie believes “negative duration fixed income assets” offer the best protection against rising rates and inflation. One of his favourite strategies involves purchasing interest only (IO) mortgage securities.

IO bonds are supported by the interest payments from an underlying pool of mortgages with the principal payments funnelled to a separate security known as a PO. The value of these securities is linked to the ability of homeowners in the pool to refinance their loans. If a homeowner refinances and prepays the principal, the PO is paid in full and the IO loses the future interest payments.

“We look at IO bonds as a negative duration asset. They perform better as interest rates rise and homeowners are less incentivised to refinance,” says Beattie.

For now the focus is squarely on short-term macro and market risks as QE2 comes to an end, Europe moves to avert a full-blown debt crisis and China battles its inflation problem. Investors are taking no chances, increasing exposure to uncorrelated strategies at the expense of beta oriented plays and implementing tail risk hedges wherever possible.

“You can see there is concern in the marketplace because everyone is buying tail risk protection and anything that offers insurance against a downturn is becoming very expensive,” says Gibb.