By Christopher Morrison
Having been an out-spoken bear during and after the financial crisis, a well-known fund manager performed a volte-face in December 2013, arguing that in light of central bank policy targeting higher asset prices, he would throw out his fundamental economic concerns and henceforth trade equity markets from the long side. But, fast-forward nine months and he remains frustrated, having still been unable to make money from a rising market.
At this point he identifies the problem as risk management – he has cut positions on occasions when volatility has spiked, only to see the market recover. The lesson is clear; stops are out: if central banks have got your back, why would you add another layer of risk-management on top? As he notes in reference to his October 2014 performance, where he recovered from heavy intra-month losses: “Pity the macro manager then who had to stop loss mid-month; that used to be me.”
This tale illustrates how even the most dynamic investors have resorted to aping a more passive strategy to generate returns in the era of ‘The Policy Trade’1. This presents a challenge to the traditional turf of macro hedge funds like our own; which look to identify swings in market narratives and idiosyncratic directional opportunities, to produce de-correlated absolute returns whilst regularly managing risk to protect capital. Is this model merely unfit for the present climate, or fundamentally broken? We think neither.
The question is how will active investors who are pursuing ‘The Policy Trade’ know when to get out? Presumably they would answer, “When the policy changes, of course!” Until that point, in the words of former Citigroup CEO Chuck Prince, “You’ve got to get up and dance”. Unfortunately, as Citigroup found to its cost, the market is seldom so obvious. Policy tightening is undoubtedly one risk to current markets (as the Swiss National Bank’s shock currency peg decision made clear), but it is by no-means a necessary precondition for a reversal. We feel this is heavily underappreciated, despite being clearly demonstrated by recent moves in German government bonds and Chinese equities. In our experience, whilst markets may fear central banks “taking the punch bowl away”, to use Greenspan’s famous phrase, the most destructive market moves occur in the face of central bank support.
A fascinating insight into this conundrum came from a survey taken at a recent Bank of America Merrill Lynch investor conference. 90% of respondents were either ‘bullish’ or ‘extremely bullish’ toward China A Shares (as of May 15th). Further, three quarters of responses to the question “why are Chinese equities rallying?” were either a ‘government put’ or ‘monetary loosening’. This was compared against a mere 3% that sited ‘improving fundamentals’! Moving forward to the present day, the Shenzhen Composite stock index fell 40% in three weeks despite the above rationale being even more valid now, considering the litany of measures announced to directly support the stock market by the Chinese authorities. What changed in mid-June? Investment management is a job of uncertainty after all, as abrupt shifts in market narratives can occur with no overt catalyst. This is the fundamental purpose of active management and risk-controls, to be able to take advantage of these shifts whilst protecting yourself from changes you cannot foresee.
Not only is risk management concerned with cutting positions, but also what positions you choose to avoid – both are embedded within our investment process. We seek to reduce our exposure to instances of negative convexity where there is the potential for a dislocated move against us. All trades in our portfolio have a high bar; including ‘policy trades’, which are assessed on their merits of economic fundamentals, valuation and sentiment. For instance, we have been constructive on the Nikkei as Japanese QE began after a 25-year bear market and with moderate valuations, but we viewed Chinese stocks as unjustifiably expensive irrespective of the policy impetus. A ‘policy trade’ is not a one-way bet, but rather just another market narrative that needs to be placed in context.
One cannot always be right, but by having risk management and positive convexity at the centre of our investment process we have produced strong absolute returns (12% p.a. since our inception in 2007) in a manner that is strongly positive skewed and de-correlated (S&P500 beta of -0.4) to traditional asset classes. We strongly believe that this approach provides the greatest chance for investors to maintain positive returns over the full economic cycle, with all of its undulations, trends and inflection points.
Christopher Morrison is head of strategy, Omni Macro Fund at Omni Partners
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