By Andrew Malek, vice president, Hedge Fund Solutions, Morgan Stanley Alternative Investment Partners
Investors continue to seek diversification and attractive risk-adjusted returns through allocations to alternative investments, including hedge funds. According to figures from the National Association of Pension Funds, average hedge fund allocations across its members increased from 2.6% to 4.1% last year.
Within the hedge fund universe, an area of particular interest for pension schemes in recent times has been the global macro strategy and its associated sub-strategies employed by funds such as commodity trading advisors (CTAs) or global tactical asset allocation (GTAA) managers. According to a Preqin report, macro and CTA strategies are among those most favoured by UK public pensions. Four of the top five hedge fund managers ranked by assets managed for pension funds specialise in global macro strategies. Pension plans are attracted by the relatively strong liquidity and perceived defensive nature of these strategies during negative equity markets, particularly those exhibited in 2008. The HFRI Macro Index showed a beta of just 0.08 to the MSCI World equity index in the 10 years to September 2012, indicating a minimal sensitivity of a diversified basket of macro and CTA managers to equities. However, to achieve the desired benefit to the wider portfolio, it is important for schemes to understand how these strategies differ and how they may complement each other, as well as how they have generated returns in the past, are generating returns today, and may generate returns in the future. Macro can be broken down into four sub-strategies : 1) systematic long-term technical 2.) systematic fundamental, 3) systematic short-term technical and 4) discretionary trading. When people talk about CTAs, they are usually referring to the systematic long-term technical substrategy. These funds trade systematically (i.e. rules-based, executed by computers), mostly using “technical” inputs such as the historic patterns of a security’s price and volatility to establish trades in that same security, often by capturing a trend. These managers sometimes attract isolated investments because of their strong 2008 performance. However, they can falter in periods of range-bound, directionless markets characterised by regular reversals. Systematic short-term technical managers employ the same strategy, but follow trends on a shorter time frequency, exhibiting different positioning and risk/ return profiles. The models of systematic fundamental managers use “fundamental” inputs to evaluate how external economic variables linked to a security may have an impact on that security’s value, rather than simply following a trend in the security’s price. Discretionary trading managers have human decision makers. They may use fundamental or technical top-down inputs to rationalise their trades, but they are not rules-based and therefore can take into account unforeseen variables that cannot be modelled. Managers within this space tend to be the most differentiated from one another, and therefore exhibit the highest dispersion of returns. The four sub-strategies will individually face challenging periods at different points in time, but combining them to build diversified macro/CTA portfolios has resulted in a more attractive and consistent risk/return profile than allocating to a single manager or sub-strategy. The HFRI Macro Index, diversified across all four sub-strategies, has exhibited capital appreciation, diversification from equities and bonds, and downside protection. As a result, diversified macro is suitable for both underfunded and well-funded pension plans. The current risk on/risk off environment creates both opportunities and problems for different subsets of macro managers. Discretionary macro managers and shorter term trend-followers are less exposed to, or may specifically exploit, this political and policy-driven market, while systematic fundamental and medium/ long-term trend following strategies may continue to suffer should this persist. While the emphasis should be on long-term sub-strategy diversification to achieve the “all weather” profile, additional benefits are possible from strong manager selection and tactically emphasising certain sub-strategies at different points in time.
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