Macro Managers Coming Through at Last

One of the disappoinments this year has been the performance of global macro managers. At the stage of half way through the year, it seemed that if a manager in this strategy had ridden the wave of QE2 inspired up-moves in equities and commodities then they gave it back by staying too long at the party, as the effects of monetary stimulus dissipated in May and from that month onwards. Those that lost a little in the 1Q may have made a bit back by mid-year, but there seemed to be too few managers that were able to ride markets in one direction and then the other with enough conviction or timing to make money across the whole of their books.

The pattern seemed to be if you made money early in the year you gave it back later. If a manager had a positive P&L in equities, they lost enough money in FX to be left around flat for the year. To be fair to the macro managers the market action this year, whether in fx or commodities or equities, has oftentimes not been in a pronounced trend for long. So it is that CTAs, the ultimate feeders off markets exhibiting trending behaviour, did not make good money until the last few months. Further, reversals have been sharp and volatility high - which makes it hard to hold onto gains even when they have been chiselled out of recalcitrant markets. The exceptions to the generality amongst global macro traders were those that tend to specialise in fixed income - the likes of Brevan Howard - for whom the trend was their friend for long enough for decent gains to be made by end of July.  

One of things that surprised me at the half way stage in the year was that so few macro managers had made much at all. Some of these big-picture managers tend to have core fixed income books, and others express their views on Chinese growth in the fx markets or in commodities. But they all may be positioned long or short, and they decide their own timing and sizing. So there is a lot of scope for the universe of macro managers to have completely different directional bets in the same market. Those that don't do much in energy, might concentrate on time spreads in softs or run a big book in credit trading. The point is they need not have correlated returns at all - in fact logically the universe of global macro managers should always have the biggest dispersion of returns amongst hedge fund strategy groups, and most of the time it does. By happenstance, taking all these different views and putting on unrelated trades across a wide selection of markets, hardly any macro managers had made good returns by the end of June this year. However the market gyrations of August and September have allowed a different story to be told for the period since.

Only this week Luke Ellis of Man Group was commenting that there was a very wide dispersion of manager returns amongst hedge funds in August. In September there was an historic extreme of dispersion of returns amongst managers running hedge funds. So for observers of, or investors in, hedge funds the returns of August and September become much more about which managers you were in, rather than which strategies you were allocated to. And practically it means that index or industry level returns for hedge funds for those two months start to be quite unrepresentative. We are well used to seeing headlines about "Hedge funds failing to deliver this month/on the year to date" based on index level returns, and sometimes (more usefully in this context) about returns across a hedge fund database being "good" or "bad" or generally different from returns on the underlying markets at an asset class level.

When the YTD numbers are close to zero, the next data point has a big impact on YTD returns. That is what has happened to hedge fund returns this year, and for some global macro funds in particular. The tables shown here are from "Absolute Return" magazine  and pick out amongst US-based managers the best returns produced last month. It is pleasing to see the marked presence of macro managers at the top of the rankings after the year they have had.  

These are good returns of specific managers in the global macro investment strategy. However, today I see that The Greenwich Investable Hedge Fund Indices give the index level returns for macro managers as -0.79% for September and -3.72% for the year so far. My experience of dealing with investors in hedge funds is that they are looking at what their specific hedge fund managers have done for them. There will be nearly no one who has experienced a return from their macro managers of -3.72% in the year to date (for reasons of position sizing and the timing of subscriptions and redemptions, if nothing else). Given the extreme dispersion of returns in September, and that macro managers have the widest dispersion of returns amongst any hedge fund investment strategy I can confidently say that no-one except an index investor has actually got a return of -0.79% from their macro managers last month. The inference is that the returns of the last two months will tell investors a lot about the quality of manager selection amongst their advisors and consultants, and amongst funds of funds. And not just in global macro.

Additional:

(Dec 7th 2011) Reuters posted an article headed "Global macro hedge fund returns fail to impress". The full article is posted here. The article mentions Louis Bacon's Moore Global Investments, Fortress Investment Group, Tudor Investment Corporation, Caxton Associates and Brevan Howard.

A Shift in Risk Appetite?

I believe in Marshallian K – so excess money creation goes into financial assets if the real economy doesn't need it. This is what is going on now in American financial markets. We are seeing narrow money creation but not broad money growth. The St. Louis Federal Reserve is showing that the current money multiplier is less than 0.9, that is, printed money is not being multiplied by the banks to the typical extent (2.0-3.0).

What is interesting so far in 2011 is the change in where that money is going. In my last article I made a logical case for flows into stocks rather than bonds based on valuation. I doubted that the flows of mutual funds would reflect that logic, but I have been proved wrong by the data releases* of the Investment Company Institute since. Here is a table showing mutual fund flows on two time frames – the top part of the table is monthly data and the bottom part is weekly data for mutual fund flows this year.

U.S. Mutual Fund Flows

Source: Investment Company Institute

The Table shows some interesting shifts. The pattern last year was for positive bond flows and negative equity flows. Whenever equity flows went net positive last year it tended to be because positive flows to emerging market mutual funds outweighed outflows from domestic equity mutual funds. So for three quarters of the year in 2010 there was a large negative bias towards mutual funds investing in American stocks.

Towards the end of the year holders of mutual funds caught on to the increasing fragility of the finances of municipalities in the States and there were net redemptions from muni bond funds. The outflows from muni bond funds have continued this year. There has been a minor pick up in flows into taxable bond funds this year, and it looks like straight switching within bond mutual funds to safer havens. Net flows across total bond funds are a small positive – and really quite small compared to last year's positive net flows. So the key word in the bond mutual fund story in 2011 is small.

The key words in equity mutual funds investing in 2011 to date are growing and domestic. After some minor end year tidying up, the U.S. mutual fund investor has continued to buy overseas equity focused equity mutual funds as before, but the new new thing is the emergence of significant buying of domestic equity mutual funds. The market for mutual funds in the United States is not like in some European territories where the largest investor in a UCITS funds can be the sponsoring insurer or bank. In the United States, apart from money market funds where institutions own around a third of the assets, mutual funds are held by individual investors. Individuals own 89% of bond funds and 91% of equity funds. And the man in the street in the US has been buying domestic equity mutual funds to an extent not seen in at least four years.

Whilst individual investors are recent converts to the attractiveness of equities, institutional investors crossed that line some time ago and at this point are expressing fervour for the concept.  The Merrill Lynch Fund Manager Survey for February (survey period 4th-10th February) contains extreme conviction on the part of institutions. The Survey overview states "The February FMS is one of the most bullish in years. Institutions have record equity and commodity overweights, very low cash levels and the strongest risk appetite since Jan‘06." It also says that "Hedge fund net exposure rose to 39%, highest since July’07. Cash balances fell from 3.7% to 3.5%, triggering our FMS cash trading rule equity sell signal." 

A mirror of the rated attractiveness of equities is an aversion to bonds in the Survey - nominal bond allocations were very low; the lowest since April of 2006 and near record lows. This is the corollary of the view on inflation (and implicitly commodities) that expectations for global inflation were the highest since June of 2004.  There is a consistency of world view too in the consensus for economic growth. Just 13% of respondents expect the global economy to weaken in the next 12 months. 


Parenthetically it is interesting that professional money managers express the same sentiment now that mutual fund flows have expressed this year  - a strong bias towards the equity markets of the developed world rather than emerging market equities. The expressed appetite for U.S. equities is the second highest ever in the Fund Manager Survey. 

The mental positioning, and Dollar positioning, of investors in equity markets combined with expressed survey views on growth and inflation give a clear road map for contrarian investors. For example I would suggest that the views of Hugh Hendry put across here (Hugh Hendry's views) were for something other than where the consensus has got to. Equity markets are overbought, and extended to the upside. However, overbought conditions can persist and there is little internal inconsistency in the market action for a tape reader to find. One of the market observers I respect puts it that the broad market "continues to demonstrate bullish resiliency".

*Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals in the weekly data. Data for previous weeks reflect revisions due to data adjustments, reclassifications, and changes in the number of funds reporting.

Top Macro Manager Talks Through Set-Ups, Triggers and Sizing Positions

This week I heard a presentation by a senior trader at one of the large global macro hedge funds which has been in business for nearly 20 years. He put across several insights into the way of working of those who engage in the strategy. The particular trades under discussion were in foreign exchange, in the Euro/U.S. Dollar, during last year.



Fundamental Set-Up

In FX there are three elements to the fundamentals that should be aligned for putting on a position, according to the trader. The first is valuation. In FX there are several valuation models which are commonly used though each has limitations. Purchasing power parity (PPP) for a currency pair is a value which is unobservable in markets, and is a conceptual level that actual FX rates pass through without pausing. Extreme deviation from PPP is taken as an under or over-valuation. The Economist uses the price of the ubiquitous McDonald's meal to calculate the "Big Mac Index", a guide showing how far from fair value different world currencies are. The Big Mac theory, which is based on an observable purchasing-power parity, says that exchange rates should even out the prices of Big Macs sold across the world.

The second element of the fundamentals to consider is the interest rate differential between the two countries on each side of the currency pair. This is not a static element, as the FX markets (spot rate) move with forward forward rates. So expectations of future interest rate differentials are what count. The relative growth outlooks of the two economies is what the senior trader emphasised in getting a handle on interest rate differentials. For my part I would say that the perceived prospects for medium term inflation are now taking a much bigger role in the mind of the market than hithertofor in looking at interest rate differentials.

The third fundamental element to a good FX set up for a macro trader is the policy environment. Last year presented a classic opportunity (in looking at Euro related trades) in that European politicians/central bankers commented on levels and movements in traded rates (CDSs as well as bond auctions and FX parities). Some of the great macro trades have been set up by governments attempting to talk down markets when their policy objectives clash with what the markets discount as sustainable. So last year was a classic of its type in this regard, though interest rate policy specifically was a stale issue according to the bulge-bracket macro trader. That is, changes to interest rate policy were not expected to be a driver of the market condition for the trade under consideration in the time-frame envisaged. For trades at the market level like those illustrated here, and particularly in FX it is very important to understand the market drivers at the time. The graphic below indicates what the macro trader stated were the major drivers for the €/$ level last year through the different phases.

Technical Set-Up

The technical set up for a macro trade can be about flows and positioning by the various categories of market participants (say hedgers, speculators and governments). For example, the Commitments of Traders report for listed US futures showed there were very high levels of Dollar bear positions just before the monthly employment report for July 2010 released on the 6^th August last year. So the positioning in the market shifted the odds of the labour market data being bad enough to move the Euro up further versus the Dollar. That date marked an interim top for the Euro versus the Dollar.

The other form of commonly used technical set up is pattern recognition, which in its crudest form is chartism. Along with the rest of the market, the senior trader from the well-known global macro firm was onto the break in the multi-quarter uptrend for the Euro (versus the Dollar) that occurred in December 2009. The Greek debt crisis powered the multi-month fall in the Euro which lasted into the middle of 2010. The break in trend of itself is often a good entry point for a trade, but as FX markets have lots of minor reversals against the major trend traders have to have tools to identify the second and third high quality entry points as the new major trend unfolds. In the middle of January 2010 there was a good secondary entry point on such a short term reversal – as is typical the secondary entry point corresponds to a support/reversal level on the previous major trend – in this case around 1.45 on the €/$ in the period 13-15^th January.

This secondary, high-quality entry point can be illustrated in another trade mentioned on this website – in Gilt futures (see here and here).

Technical Set Up for Trade in Gilt Futures Showing High-Quality Entry Point

The significance from a money management perspective is that the second entry point - as the security price accelerates away from a key support or resistance level - can be a higher conviction entry point than the first. This is because the investment hypothesis ("the market is going to go down", say) has been tested by market action and passed the test. So depending on style, the macro trader can trade in several risk units at the second entry point. In no way is the second entry point a secondary entry point!

The global macro trader also disclosed the use of a particular tool to assess sentiment – the world wide web. The fund monitored the occurrence of the phrase "quantitative easing" on the web in August, September and October to ascertain the degree of dominance in the minds of investors.


Trigger

Global macro trading is often about assessing the persistence of action by the various actors in the market drama. It was interesting that the senior macro trader said that the trigger for putting on the position was often the behaviour of the markets themselves. Note that the crucial observations are across markets, not necessarily from market action within the market under consideration. So for the €/$ last year the maturity of the Euro rally that began in June was under consideration in August by the trader because the co-movements of the S&P500 (as a proxy for global equities) and the fx rate diverged. The €/$ and the SPX had synchronised price changes for a period of some months, but over the first few trading days of August days the S&P was flat whilst the € was still appreciating against the $. For the macro trader this signalled a change of behaviour was imminent for the Euro/Dollar relationship because the S&P action signalled at least a pause in the driver for the FX rate (the slowing US economy). To quote the trader directly, "divergences between markets are the best clue for market behaviour. A correlation break that lasts for one-to-two days and can indicate a movement to follow that lasts for 2-3 months." He also stated that more than 50% of a macro trader's insight comes from understanding the message of the markets, that is the behavioural inference is key. Like many traders, including those with a macro framework, the presenting macro trader only puts capital to work if the market has already started to move in the direction he wants to play.


Sizing

Sizing of positions in macro is usually a function of risk/reward and correlation. The senior trader didn't mention correlation himself in this regard, so we'll concentrate on the potential profit and loss as the key input to position sizing. The target price and stop loss levels for positions in markets are typically placed at or near significant support and resistance levels – the difference between current price levels and these two levels gives the upside/downside ratio for the potential trade. The potential loss between current levels and the stop is used to scale the maximum position size. A loss of say 5% on a position that is 20% of the gross equity of the fund would give a portfolio level loss of 1%. If two percent loss at the fund level for a single position is the outer bound then a 3% loss to the stop would equate to a 24% of equity maximum position size. The principle is determine how much you are prepared to lose – "anything else is bad discipline, or has ego in it," admonishes the trader.

This particular macro fund also uses drawdown from peak as an additional risk limiter at the level of the individual trader. So the risk capital of the trader will be reduced if his P&L is down 5% from his own peak, and he will be out of the market for a period if he loses 10% from his peak P&L, even if he is still positive on the year.


Closing the Position

The macro trader acknowledged his belief in the concept of reflexivity – Soros' concept that positive price changes themselves impact how positively investors think about the market – such that prices can waterfall down or continue upwards way beyond most expectations. Conceptualising potential price changes and unusual market impacts helps macro traders mentally prepare for a range of market outcomes. But still an all, positions have to be closed even after exceptional profits – so what feeds into the decision making at the closing of a trade? "A position should be reviewed when a price target is hit, and should be closed for sure when a lot of the market has joined you in that position."

How do you make money in macro trading? – "You need to take risk aggressively to make money, but you need to take it well." 



One of the reasons I posted this article is that the trader uses several methods I use in my own style of investing. If you run a hedge fund and would welcome input on your processes (investment, research and risk management) from my consultancy or want to persuade me to share my expertise full-time contact me on s-kerr@tiscali.co.uk 

Consulting One - Team Working in Hedge Funds

There is no such thing as a perfect hedge fund – we are all trying. So in my role as a consultant to hedge fund portfolio managers (PMs), I am usually carrying out remedial work in some dimension. Sometimes it can be about the positioning of hedge funds commercially, but usually it is about what the portfolio managers are doing. I'm going to write a series of articles about my consulting work – this is the first.

One of the key elements I have to investigate in my consulting work is the relationship between team members. I'm going to discuss one project I did with two joint-portfolio managers of an equity long/short hedge fund. This discussion is to raise issues and to describe ways of working. The team in this case comprised two members, PM "A" and PM "B", and they ran reasonably successful long-only products. There are three topics in this snapshot – the ground rules were not well established in this example, there were some important differences in style (personal and investment style) that got in the way of successful team working, and one of the portfolio managers had an unusual trait which had a bearing on his money management style. Finally I have included some of the solutions I gave to the portfolio managers and their boss.



Ground Rules

It is not unusual for a team to move from running long-only money together to managing a hedge fund. In doing so there will, of necessity, have to be new rules of engagement. Clarity of the decision making process is very important, for internal purposes (for accountability and reward), and for external parties like potential investors. It is important that there is agreement about the specific roles to be taken, and that there is a buy-in from the off of the structure adopted. A successful agreement or understanding will have a level of detail in it that may surprise some.

One of the most basic areas not made explicit in this case was the fund's objectives and the consequences that follow from that. The two portfolio managers did not have a common, agreed understanding of what returns would make the fund they both ran commercially attractive. Therefore they did not feel the need to measure their portfolio level risk and monitor it - where they taking too much or too little risk? They just didn't know.

Another consequence of this lack of commerciality in terms of return profile is that they had no notion of what was a the worst monthly loss they could sustain without putting themselves out of active consideration by investors. The worst monthly loss is a key metric both internally and externally. Internally the metric gives an implication of where portfolio level stops should kick in. Externally it is one of a number of measures that give investors an idea of what the whole risk profile should be like – number of winning-to-losing months, drawdown, recovery period, and what is a good and bad month for the style of investment.

One of the issues which provoked some tension in the relationship between the managers was how they split between them the sectors of the equity market they worked on. It was fine, and indeed seen commonly elsewhere, that the market was split into two – one half invested in by one portfolio manager. The tension, such as it was, arose because PM B did not want to be excluded from investing in some of the sectors covered by PM A. It was never satisfactorily covered in discussion at inception in the mind of manager B, and that oversight hung over discussions in the ensuing two or three years.

It is quite usual for a PM in a team of portfolio managers to be able to initiate positions without reference to their partners. But how the team will react to change for the positions (in size or price) does need to be covered in the ground rules. Is there any right of veto, is there a different scale of decision made when the partners don't agree? Once a position is owned is it subject to hard or soft stops – do both partners have to adhere to review and exit levels? For the fund and team under discussion one of the partners was much more engaged in challenging the positions initiated by the other partner. Whilst the partners whose positions were under discussion saw this as a personal style point (one partner was just more vocal/forthright than the other), the other partner saw such challenging discussions as part of the investment process. This difference in perception and therefore activity could easily undermine a relationship under pressure because of returns.



Differences Between the Portfolio Managers

Having had some preliminary discussions for an overview, and discussed at some length how the two portfolio managers spent their time and what structure they had in place in their investment process, some clear points of difference came through. To explore these further I conducted separate structured interviews – asking the same questions to each portfolio manager gave a chance to compare attitudes, preferences, and perceptions of the two team members. To put the following list of differences into context I quote from my written report on the managers: "The managers have fantastically complementary philosophies on the market. They get on very well on a personal basis. In fact they have worked incredibly well together with some quite significant differences in tactical approaches (strategy being broadly agreed)."



Differences in Time-Frame

PM B is more comfortable with the shorter term time-frame that running a L/S hedge fund usually requires. Specifically B is much more willing to incorporate the current implications of market action into his market view by stock than PM A.



Differences in seeing Companies and Stocks

They have a similar level of respect for each other's views on companies (specifically differentiating between stocks and companies). However, when looking at equities of companies (shares) portfolio manager B can be as dispassionate about shares as he can about companies. This is in contrast to PM A – who is still prepared to argue with markets when he likes the company, even when the share price action is saying that the market does not agree with the positive (or negative) view of the company in the short term. So the feedback loop from owning the shares – the P&L – is negative for the position and getting worse (e.g. if it is a short the shares are going up) and that message from the markets, even if it is just about short term timing of the position, is being ignored.



The Fall-back Input - is it Technical or Fundamental?

(or to put it another way "short-term or long-term" or even "stock market or real world")?

Through the structured interviews of the portfolio managers it is possible to tease out where there are differences between the team members on research time. For example, in this case PM A suggested that they needed to have 300 company meetings a year, PM B thought that 100 meetings a year with company management was enough. The different perceptions of what was needed fed through to the weighting given to the fundamentals. Or, as likely, reflected the biases the managers brought into the discussion. Under pressure PM A will rely on the fundamentals to win out, whilst PM B will listen to the message of the markets and will be prepared to cut losing positions.



Conviction or Confidence?

Operators in markets, particularly traders, but to a significant degree portfolio managers as well, bring with them the baggage from their previous life experience to their decision making. So sometimes in analysing a team it is not that there are subtle style differences so much as one of the team is coming from somewhere else attitudinally (or characteristically). There can be a one-sided difference, if you like. Portfolio manager X brings with them epsilon, whilst portfolio manager Y has acquired a trait of zeta.

Through the structured interview it came through very strongly that PM A (or the Alpha member!) had a strong conviction that the most important characteristic of a successful portfolio manager was confidence. It is true that someone operating in markets has to have the belief in themselves sufficient to take on the markets, but the very strong emphasis on confidence manifested itself in the investment process in this case. This happened in two ways.

The first expression of individual confidence, if you like an assertion of confidence of an investment view, was in position sizing. Having done the analytical work PM A would take what I would consider a large position for his initial holding in a stock. Almost by definition the stock was bound to be perceived as under-valued by the market at the point of taking the initial position. If the market further under-valued that (long) position by marking the shares down (causing a loss) this would create a "better" (cheaper) buying opportunity, so PM A would have some bias to expressing confidence in his initial view of the shares by buying more. But the more important point is the size of the initial holding – he may or may not add to the position. Portfolio manager B would take an initial position of less than half the size of that taken by PM A, and look to add to it.

The second expression of confidence was the maintenance of positions of large size. PM A would always look for a further up leg in longs he owned for fundamental medium-term reasons. PM B would have a bias to trim successful positions as the positive momentum waned (to top and tail the positions). There was clear anchoring by PM A in sticking to previously successful positions, and to cut them would, in his mind, be an expression of a lessening confidence in the initial research.





Recommendations and Suggestions to Address the Issues Raised

In this particular case I wrote a 30-odd page report to the CIO of the firm as well as presented my conclusions to the portfolio managers that ran the equity long/short hedge. In the report I made a series of tiered written proposals – key recommendations, other recommendations, and finally at a more elective level, some suggestions. In response to the issues raised above here are some of the Recommendations and Suggestions forwarded:

• You should select what you consider to be "high potential" company meetings for both PMs to attend. This will enable higher conviction positions to be established at an earlier stage with a common background on the company.
  
• Be very clear and explicit (shared between you) on the reasons for having a position in a stock. Indeed there may be five potential drivers for a stock to go up (or down), but you must be clear why you own it (are short of it). The stock position should be in a portfolio for reason of how it will contribute to the portfolio characteristics (factor bets) as much as any stock specific reason (factor). This allows you to control portfolio shape in an informed way. Drift in any one position may not matter, but when aggregated across a portfolio, factors like capitalisation effects will turn you into heroes or zeroes promptly in the hedge fund format. Own positions for a reason and stick to it.
  
• You both have to have the capacity to invest in all sectors of the market.
  
• You need a few mechanistic rules that you can apply to take even more of the emotion out of decision making:
  

1. Automatic locking in profit/reducing exposure after a stated return. So a trading position that gives a 15% plus return in two weeks is completely sold, an investment position that gives 25%-plus return in a couple of months is halved automatically. The trading position can be bought again if it is equally attractive at some point. If the fundamentals still justify a larger position (they have improved since original position taken) then the investment position can be made larger.
   
2. You need a review level and hard-stop level per position. I suggest a 10% loss on book should be a review level, and 15% is a hard stop level (sell whole position, no exceptions). As a reminder the ABC Large Cap Fund has a hard stop at 8% for non-core positions and a hard stop of 10% for core positions, and the ABC Europe Fund has 5 and 10% respectively.
   

• Either can initiate a position, as at present. However there must be a vote before ADDING to a position – both PMs must agree.
  
• Just as you need to know yourself to be an investor, you need to know your partner if you have joint and several decision-making, rather than having a presiding genius. Because you demonstrate some differences in personal style, there are times when you don't understand where your partner is coming from. I suggest that you complete a Myers-Briggs Model™ (Extravert, Introvert, Intuitive, Sensor, Thinker, Feeler, Judger, Perciever) questionnaire. This is particularly relevant for times of stress – we each revert to a fall-back way of operating and this is the kernel of what you need to know of each other for managing money as a team. If you understand more about where each other is coming from (not intellectually but in personal style) then you will be able to tolerate the differences more easily.
  

Clarium Redux - Still Arguing with Markets, Still Losing

I am grateful to the website market folly (www.marketfolly.com) for this input on Clarium Capital, the global macro fund manager.

Peter Thiel, source:Bloomberg

" Even more shocking perhaps is that the downward spiral at Peter Thiel's hedge fund Clarium Capital has continued. ZeroHedge noted that Clarium lost 6.1% in the first three weeks of March and was now down 5.4% for the year. This all comes as US equity markets are up over 6.4% for 2010. We're not quite sure what's going on over there but after a fantastic start to the fund, the last few years have been quite rough on them, to put it politely. They were down 25% in 2009 according to our hedge fund performance numbers post. However, as of the recent performance data, they were still up 210% since inception.

The Limits to Fundamental Conviction – Clarium Capital

In August 2007, perfectly catching the first public intimations of a financial downwave global macro manager Clarium Capital, then of San Francisco, dispatched a manager letter that took a negative view on economic growth, real estate and the stock market. In the letter they wrote ""We have begun a post-Long Boom phase that can be called the Long Goodbye. Returns during the Long Goodbye will be lower -- perhaps half as much -- than those of the Long Boom."

The firm argued that the developed world has entered a period of lower returns in which interest rates and economic volatility would increase while growth in corporate profits and global expansion decline. To adjust to this new reality, the firm explained that people must work more, consume less and compensate for lower returns by using more leverage -- borrowing more, that is. The prudent response would be to work longer and cut consumption, but up to that point the reaction had been just to borrow more, Clarium said.

Chillingly, Clarium predicted "that higher leverage has made markets much more vulnerable to outside shocks that will force "painful" de-leveraging and a reduction in liquidity." Clarium built these economic scenarios and market forecasts into portfolios through several investment themes. One was being short the US Dollar, and another was shorting shares of leveraged companies. In the second half of 2007 and early 2008 Clarium made stand-out returns on these themes (see table).

2007 Returns







2008 Returns






Clarium's excellent research had also put them into the camp that believed in the peak oil concept, making oil prices more sensitive to small changes in the demand/supply balance, and giving prices an upward bias over the long term. As it turned out, Clarium's investors didn't have to wait for the long term to arrive and for a payout on the long energy positions Clarium ran – in the first half of 2008 the oil price accelerated to the upside and Clarium's returns reflected big long exposure to energy, gaining 11.2% in May 2008 and 16.0% in June.So in the middle of last year Clarium Capital's principal, Peter Thiel, was a "Master of the Universe". In the first six months of 2008 his Fund was up 57.9 percent. Significant inflows followed the turn of the year returns, and by the end of July 2008 Clarium Capital Management had assets under management of $7.3bn.

Clarium's Peter Thiel, source:Bloomberg

Clarium stayed short of the US Dollar and long energy as the start of the second half of last year, so in July and August gave back some of the gains of the first half of 2008. Bets against the world's reserve currency, the US Dollar, in a time of crisis would not have helped returns at the time of the collapse of Lehmans and the follow on problems at AIG and the UK banks (October/November last year). So after a bang-out first half, Clarium ended 2008 having made a small loss of 4.5%. Better than most hedge funds across all strategies, but the Clarium returns in the second half of 2008 were worse than the peer group global macro managers, and across the whole year the small loss was delivered to investors with very high volatility. Many macro managers run steepener trades as portfolio insurance for a liquidity crisis, so many macro managers were positive in each month of the final quarter of 2008. Clarium didn't carry that insurance and had losses in two out of three months. Like the whole industry Clarium Capital suffered major redemptions in 2008, but the scale of some of Clarium's monthly losses hastened investors to the exit. AUM were $2.5bn at the end of 2008.

2008 Returns






Peter Thiel has been quoted as saying recently that "There was a degree to which the financial economy has been extremely decoupled from the real economy." He has noted that he didn't expect the S&P 500 to rally 62 percent, its steepest advance since the Great Depression, at the same time that the proportion of Americas without a job rose to a 26-year high. The Clarium fundamental call has been that the economic recovery would be at best constrained."A real, sustainable recovery is not possible without productivity growth," said Clarium's Chief Economist Kevin Harrington. "The recovery is not real," he says. "Deep structural problems haven't been solved and it's unclear how we will create jobs and get the economy growing again -- that's long been my thesis and it still is." He continued, "The government has helped stabilize the banking system, but I'm not sure we have a path toward sustainable growth, partly because consumers are dealing with debt and other issues, even as an energy crisis looms. It always feels unpatriotic to be negative. But too few people are focused on the real problems."

Thiel himself is of the same mindset: "I don't think that a recovery is impossible. I do think its quite hard to get to a situation where you have a lot of growth in the economy without running into basic constraint problems.

 "The key thing in the US is going to be doing more with less. If you try to do the recovery by just doing more of the same and if the recovery is going to consist of going back -- to the housing bubble, going back to leveraged finance, lending money again like crazy, going back to 2005 -- it just seems to me like you're setting yourself up for a real problem. I think you would run right back into four dollar a gallon gas prices and it would sort of correct itself [back into recession].

"Longer term I'm hopeful. I'm not wildly optimistic…But I don't think it gets driven by the financial system or even has that much to do with macroeconomic policy. I think it basically has to do with getting innovation working again. I think that's a very long term trajectory. I'm pessimistic in the sense that I don't think people are focusing on that enough."

Implementing these views Clarium was long the Yen and Dollar in the first quarter of 2009. . The Dollar positioning in the first half reflected an implicitly deflationary view, and Clarium has been long of high-quality bonds based on the view that fear will prevail in markets in 2009. That fear in terms of stock markets peaked in March, and since then stock markets have rallied hard. It appeared to the investment professionals at Clarium that valuations on equity markets quickly became rich, and they have shorted stocks into the middle of the year. And paid for it:

2009 Returns






Global macro managers are paid to take a view on how the economic environment is going to impact market prices. If markets reflect the fair values of stocks, bonds and the parities of fx rates global macro managers have no trades to put on. They trade on where prices are going, given their view on the dynamics of economic growth, final demand, inflation and job growth, in the context of markets subject to the emotions as well as the rational thinking of investors.Modern form macro funds aim to have five or six themes running in their portfolios. The themes are only distinct to the extent that they are uncorrelated. So if two trades are long yen call options as a probabilistic bet that the carry trade unwinds in emergencies, plus a yield curve steepening trade then there are two trades that will work for the same scenario, and they will be tightly correlated when you expect them to work. Long gold and long index-linked bond trades can be thought of the same way. Late last year was a period when correlations between positions were either +1 or -1. So it was very difficult to construct trades with a macro take on markets that were not very correlated (positively or negatively).
  
Many managers in macro use VaR type measurements of portfolio risk. This methodology is flawed but still useful for macro managers because it allows risk assumption across different asset classes to be measured on a common basis. Although macro managers are not as micro-controlled as equity hedge managers in risk-assumption boundaries they can and do vary risk assumption according to shifts in markets, including regime change, which is what we saw in the Autumn. So macro managers have a free choice about maintaining, increasing or cutting their risk assumption as market values move, just like hedge fund managers in other styles.
  
One of the tenets of running money, particularly for other people, is that you earn the right to take risk. On an individual level Peter Thiel did that by co-founding PayPal, and so started Clarium with capital which was merited. The annual return series for Clarium given below shows the classic global macro pay-off profile: the portfolio is run as a series of bets some of which become highly profitable. In concept a global macro fund runs a series of themes are run to give a chance to smooth out returns, and losses are limited by three things: trades which have natural downside protection (like the bond floor of convertibles, or a hard asset value), strategies are put on with delineated stop-losses from the outset, and options are used to implement the views. So the return series should look like a strip of option positions – occasional big pay offs interspersed with dull returns (small losses and small profits).

Annual Returns of Clarium LP

In the case of Clarium several of the tenets of running money, and running money in the modern global macro format specifically have been broken. These are matching stop-losses with the risk/return profile, diversification of theme, and arguing with the market without a suitable limit.There have been 14 double-digit monthly returns in the Clarium performance history, both gains and losses. That scale of monthly return is only feasible with the use of leverage. The use of leverage carries the inference of high conviction and/or investing capital in low volatility assets. Soros used leverage (re-hypothecation) on his bond positions in his heyday, and traded forward currencies in large size using the implicit leverage of forwards with no margin in low volatility instruments. So leverage per se is not a bad thing, and in normal markets is necessary to potentially generate 20% absolute returns from low volatility instruments.

Soros used to load up on a position when it started to turn his way - the foot-to-the-floor version of risk assumption. That is the investment hypothesis had been tested in the market and shown to be positive, so reinforce the winners. Contrarily, the markets are very good at teaching lessons in humility – so if a position started to ship losses Soros was all over it , and mentally able to cut it and re-visit at a more opportune time. So capital was dynamically applied at Soros Fund Management with the feedback loop of the P&L delivered by the positions in the market.

The other feedback loop that managers use is the fundamentals – have they mapped out as forecast? Is the road-map of the progress of the macro factor turning out as expected at this point? Some, indeed many, managers will argue with markets (running a negative P&L) on the basis that their fundamental view is being borne out in the real world away from traded markets. So if trade deficits are the key factor in monitoring fx rates at the time, and the trade balance is progressing as expected then managers give themselves the right to argue with the markets for the time until their conception is generally recognised in FX cross-rates. Of course there may be other factors influencing the fx rate, and the rate of progress may not be as laid out in the road-map. There is room for judgement, but not for behavioural biases counter to the facts.

In the case of Clarium the losses of August and October last year are prima face evidence that the tenets of macro management were not being followed. If there were effective stop losses at the portfolio level or by theme and the portfolio themes were indeed non-correlated then a single month's loss should not reach 13 or 18%.

As stated, last Autumn was exceptional in the shift on volatility and correlation. However part of what investors pay for in the modern hedge fund world is superior risk management. Exposures should be cut at a hedge fund at the portfolio level to ensure that the target maximum monthly loss should not be breached. Clariums' track record from 2002 to 2007 showed 3 monthly losses of 11% or just over 11%. Given the size and number of positive months that maximum monthly loss was (just) tolerable. But a loss of 18% was not and is not. Exposures should have been cut intra-month so that the target maximum loss was not exceeded. As much as anything else that was a logical reason for investors to withdraw their capital, as they did towards the end of last year at Clarium.

This year is different again. It is clear that the Clarium view on the economy is the same now as it was at the beginning of the year. That is fine – it has been a disappointing economic recovery in some senses, and so in macro-economic terms Clarium have been broadly correct this year, and may be borne out on their forecasts beyond this year. How those views have worked out in traded markets has been less successful – Clarium were down 15.8% by the end of September.

It looks like September 2009 has been a signal month for Clarium Capital Management. The Clarium Fund lost 8% in the first 14 trading days of the month. Between between Sept. 11 and Sept. 19 Clarium cut leverage from 4.2 times down to 1.4 times equity, and closed the month with a loss of 8.1%.

I would contend that the commercial position of Clarium Capital Management LLC was different this year than during the rest of Clarium's history. The large losses of August and October last year, the withdrawal of investor's capital last year, the increase in frequency of losing months, and the fact that the Fund is well below its high water mark (so vulnerable to staff losses) all shout to me that the remaining capital ($1.6bn at the end of September 2009) should be run more conservatively than hithertofor.

I do not think that managers in the position that Clarium was in this year should argue with the market to the extent in terms of scale and time that Clarium did. Being right on the economy only mitigates the position to the extent that positions in markets make money. There are natural limits to risk assumption in global macro, and to an extent Clarium lost some of its degrees of freedom in that regard from the outcomes last year. This year the natural limits to fundamental conviction for the firm should have kicked in a lot sooner than September.


The above was put together using material from various sources. I acknowledge the use of quotations and data from Bloomberg and The New York Post. The use of appropriate feedback loops and money management are core concepts used by Enhance Consulting, Simon Kerr's consultancy.
useful link: manager letter (April 2009)